ECONOMICS - Carl Schurz High School

ECONOMICS POWER GUIDE

I. WHAT IS A POWER GUIDE?....................................................2

II. AUTHOR’S NOTE ON USAGE................................................. 3

III. CURRICULUM OVERVIEW........................................................4 IV. FUNDAMENTAL ECONOMIC CONCEPTS................................ 5 V. MICROECONOMICS............................................................... 25

VI. MACROECONOMICS............................................................. 70

VII. INTERNATIONAL TRADE AND GLOBAL DEVELOPMENT............125

VIII. POWER LISTS.......................................................................... 145

IX. POWER EQUATIONS.............................................................. 173 X. POWER TABLES.......................................................................175 XI. BIBLIOGRAPHY, ACKNOWLEDGMENT.....................................182 XII. ABOUT THE AUTHOR.............................................................. 183

BY

JOSEPH F. SLOWIK AND DEAN SCHAFFER MICHIGAN STATE UNIVERSITY ’04

WHITNEY YOUNG HIGH SCHOOL ‘00 STANFORD UNIVERSITY ’10 TAFT HIGH SCHOOL ‘06

DEDICATED TO ALPACAS.

© 2007 DEMIDEC RESOURCES

ECONOMICS POWER GUIDE PAGE 2 OF 185 DEMIDEC RESOURCES © 2007

WHAT IS A POWER GUIDE? Hello there, Decathletes and alpacas alike! My name is Dean Schaffer, and as this year’s Power Guide Coordinator, I’ll be a tour guide of sorts for your visit to the strange and exotic land of DemiDec. Today we’ll be observing the Power Guide.

Veteran Decathletes and past visitors will know that the Power Guide is a relatively new species that evolved not long ago from a need for a more concise, fact-oriented study guide in the Decathlon world. The creature is still in relative infancy, but all Power Guides are written in bullet form. Each bullet generally contains one testable fact. DemiDec Resources (a distant cousin of the Power Guide in the same genus) will help you learn a subject; Power Guides will help you review and master it.

Because the nature of the Power Guide can make it unruly, they are written only by current or former Decathletes who scored at least 8000 points in competition. These authors are all highly qualified to tame the beast so that it best serves you.

At first glance, Power Guides often appear bigger, fiercer, and more intimidating than the USAD Resource Guide (another of the Power Guide’s relatives, but in a different genus), but don’t be fooled: the Power Guide’s format makes it look bigger than it actually is. Bullets take up more space than prose, and Power Guides have large margins to facilitate note taking. Further, the Guide’s posterior portion (otherwise known as its latter half) is chock full of nutritious study tools that will help you digest the material as efficiently and quickly as possible. These tools include lists, tables, and timelines.

Two years ago, Joseph Slowik wrote the Economics Power Guide. Last year, I rewrote it. This year, I revised it.1 This guide includes both Joseph’s research and everything I learned from the two years of economics courses I took as a Decathlete. Economics tests often include ridiculous questions from way out in left field; I hope this guide will help to bring that distant left field a little bit closer to home.2

Economics has long been one of my favorite Decathlon subjects. Many of the concepts and ideas just seem to “click”—they reflect real life situations. Unemployment, satisfaction, indifference—these are a part of life and a part of economics. Oftentimes, thinking of real life examples is the best way to clarify a tough concept.

My very first econ teacher once told my team an “economics joke”: Two normal guys and an economist are stuck on a desert island. They’re all desperate to get back to civilization, but the first two have no ideas. All of a sudden, the economist says, “I’ve got it!” “What, what?” ask the other two excitedly. The economist, beaming with pride at his ingenious solution, declares, “First, let’s assume we have a boat…” Like you (probably), I didn’t laugh when I was first told this “joke.” After two years of studying econ, I finally get it.3 Hopefully, when you’re done, you’ll get it too.

This time, I’ll continue with you as your tour guide with some help from Joseph. Enjoy your stay!

Sincerely,

1 Diminishing returns, anyone? – Dean 2 Sorry. I played baseball for over ten years. – Dean 3 But, to be honest, I still don’t laugh. – Dean


AUTHOR’S NOTE ON USAGE The very nature of the economics event makes this guide a little different from the others. Since there’s no given curriculum for 85% of the event, earning a high score is dependent on learning a broad swath of economic knowledge. That’s where this guide comes in. The USAD Economics Basics Guide is a pretty pathetic excuse for a study tool, which is probably why this guide is now sitting in front of you.

This guide includes all parts of the USAD outline of the economics event (except for the American Civil War, which can be found in the Civil War Economy Power Guide). However, it also covers many topics not mentioned in the outline because past tests have often included such outside information. Our goal is to prepare you for both the easy questions and the random ones.

Key economic terms, names, books, etc. are emphasized in bold type. These bolded terms all appear after the main text of this guide in the Power Lists, which are organized by section (fundamentals, micro, macro, and international). Other lists cover economic legislation, theorists, and more. The Power Tables (just after the lists) offer a more comprehensive review of several general topics.

A note on content: in any instance where “goods” or “services” are discussed, we are really referring to both goods AND services unless otherwise specified, as both are the products or results of economic activity. Additionally, unless noted or context indicates otherwise, “individuals” can mean individual persons, firms, or even states. We sometimes use the term “agent” instead to avoid confusion.

Studying economics certainly requires more discipline and willpower than studying the other subjects because you quite simply have to do most (if not all) of the work on your own. There’s no USAD guide to lead you in the right direction. That being said, I commend you for picking up this guide. Since economics can certainly be difficult, we’ve included a large number of examples and graphs to make key concepts and ideas as clear as possible.

Unlike in other events, concepts are just as important as terms in economics. Knowing the theories behind the terms will help you out on many a question; as you prepare for competition, try to gain an understanding of the terms you’re trying to memorize. You’ll need this comprehension to conquer the inevitable question that comes out of nowhere.

So, study hard and good luck! May you have a “perfect competition”!

-Dean and Joseph


CURRICULUM OVERVIEW Economics is a social science. It revolves around the study of markets, exchanges, and satisfaction. The study of economics is traditionally divided into four areas: fundamental concepts, microeconomics, macroeconomics, and international trade.

In the first section of this guide, we will discuss the basic principles underlying economics. We’ll learn about the general types of economies, markets, and decision-making. The concepts we encounter here are critical in understanding the rest of economics.

Microeconomics focuses on consumers and businesses (firms). What factors influence consumers’ decisions? How do firms decide how much to produce? What are the different types of markets? How does consumer activity affect firms? These are all questions we’ll be addressing in microeconomics.

Macroeconomics deals with the economy as a whole. What is GDP and how do we measure it? What role does the government play in the economy? What are inflation and unemployment, and how do they impact society? In many ways, macroeconomics takes many of the concepts of microeconomics and applies them on a national scale. Many consider macro more difficult than micro because macro is a bit more abstract. The ideas that we’ll discuss, however, are extremely relevant to our lives today.

International economics is the final area of economics we will study. International economics examines how nations interact and trade with one another. We’ll also discuss international trade organizations and the exchange of currency.

If competition is rapidly approaching and you find yourself running out of time, you may want to focus on macroeconomics. The most difficult questions generally come from macro, and tests are often more heavily focused on macro than on any of the other three areas (despite what USAD may say in its outline).

Don’t forget that seven to eight questions will also be about the economy of the U.S. during the Civil War. Information about the Civil War economy can be found in Meaghan McNeill’s Power Guide.

Below is a pie chart that details the breakdown of test questions in the economics event.

Fundamentals

15%

Microeconomics30%

Macroeconomics

30%

Trade &

Development

10%

Civil War

15%


FUNDAMENTAL ECONOMIC CONCEPTS

POWER PREVIEW POWER NOTES

This section gives a brief overview of basic economic principles and the logic of economic analysis. Some of the information introduced in this section will be covered in greater detail in later sections.

15% of the exam (7 or 8 questions) will be from this section, but the concepts in this section can appear in questions on other sections

7 questions from the USAD practice test are on topics from this section

See the bibliography at the end of this guide for sources used

Scarcity and Wants Unlimited human wants, but scarce resources

Wants are unlimited because they can never be completely satisfied When one want is satisfied, a person will think of another Wants are fundamentally different from needs

A person can satisfy his needs Resources are scarce simply because not enough exist to meet our limitless desires

Only a finite amount of resources are available at any given time Resources can be put to unlimited possible uses

We can always think of new uses for existing resources Even time is scarce: there are unlimited ways in which we can use the limited time we

have Human beings (or economic agents) must therefore decide how to allocate resources

among competing wants Decisions involve choices among competing allocations of resources The ultimate goal in deciding which wants to satisfy is to maximize utility

Utility is essentially satisfaction When making decisions, therefore, we attempt to get as much happiness out of

them as possible The definition of economics

Economics is a social science that seeks the optimal allocation of scarce resources to satisfy unlimited wants

Economics allocates resources by examining costs, benefits, and the trade-offs between these two inherent in any decision

Our goal is to maximize benefit while minimizing costs Doing so is called optimization

Costs Any given activity has two distinct types of costs

Accounting cost is the simple monetary cost of a good or service Another name for this type of cost is explicit cost It is also referred to as “out-of-pocket” expense because it’s the money that,

well, comes right out of your pocket, so to speak When you buy gas for your car, for example, the price of the gas is the accounting

cost of your purchase


Opportunity cost is the value of the next-best alternative to a given activity, good, or service4

Opportunity costs are present in all economic choices For example, the opportunity cost of reading this Power Guide is spending the

same amount of time (and effort) on an alternative activity5 Opportunity costs reflect the nature of a trade-off

By choosing to allocate resources in one way, you are deciding not to use them in another way

Opportunity cost is also known as implicit cost In our previous example of buying gas, your opportunity cost is the time you spend

driving to the gas station and filling up your tank This time may or may not have a monetary value (depending on if you could

have been somehow making money instead of getting gas) A good without an opportunity cost is known as a free good

Very few examples of free goods exist One example, however, is air

Air is “free” because there is no alternative to breathing,6 not because we don’t pay for it

The sum of both accounting and opportunity costs yields total economic cost Economic exchanges and deals also have transaction costs

Transaction costs are the costs of making the economic exchange itself There are several types of transaction costs

The first is the search and information cost This category includes the cost of the time spent to determine if the desired

good is available, who has the best price, etc. If Barefoot Ben decides to buy Air Jordan basketball shoes, the time he spends

looking for the best place to buy them constitutes his search and information cost

The second is the bargaining cost The bargaining cost includes the cost of the time taken for the two parties to

come to an acceptable agreement, draw up a contract, etc. If Barefoot Ben decides to buy a new car instead of shoes, the time he spends

haggling with the salesman and signing the contract constitutes his bargaining cost

The third is the policing and enforcement cost This type of cost includes the cost of all the time and effort spent to ensure that

the other party of an agreement sticks to the agreed terms If Ben’s car is still under warranty and needs a repair, for example, his policing

and enforcement cost includes the time he spends to make sure the car company pays for those repairs

If the company refuses to do so, his policing and enforcement cost will include the monetary cost of hiring a lawyer and going to court

Transaction costs of one type or another are inevitable with nearly all economic exchanges

4 In layman’s English: the opportunity cost of what you do is the value of what you gave up to do it. 5 Like having fun. – Zac 6 But if you can find one, you’ll be rich. – Dean


The four assumptions of economics7 In studying and discussing economics, we make four assumptions

People are rational People are greedy

In other words, their desires are limitless (as mentioned before) People act in their own self-interest Resources are scare (as discussed above)

Scarcity is a consequence of our second assumption The four basic factors of production

Available resources are divided into four factors of production: land, labor, capital, and entrepreneurship

Land consists of all “natural” resources Land includes actual land as we normally conceive of it (such as a forest), but it also

includes resources on the land (such as water or minerals) Goods extracted from land are known as raw goods or primary commodities (such

as copper, trees, or oil) In economics, payment for land is called rent

Remember: by land, we mean all natural resources Capital includes all goods, and even processes, that are used to make other goods or

services Capital has two distinct forms

Physical capital includes machines, devices, or goods which are used to produce other goods

Examples include company trucks, office servers, factory machinery, and cash registers

Human capital includes human capabilities These capabilities include training, experience, intelligence, and knowledge Education, therefore, is an investment in human capital

Payment for capital is called interest Labor consists of human resources

Labor can take the form of pure physical activity to produce goods or services It can also involve mental work, such as writing a Power Guide Human capital includes the skills and capabilities of individual workers while labor is

workers’ actual efforts Payment for labor is called wages

Entrepreneurship is a type of human resource, but it is very different from labor Entrepreneurship entails combining the other three factors of production in new or

unique ways to produce new goods or improve the production of existing goods Entrepreneurial activity, by definition, involves risk-taking

Because entrepreneurs look for new ways of doing things or using resources, there’s no guarantee that they will be successful

Entrepreneurs risk failure through their activities and, thus, demand payments above their normal return as an incentive

Payment for entrepreneurship is called profit The production possibilities frontier

The primary reason people use resources to produce anything is to satisfy a want To produce goods, persons (or businesses) combine the four factors of production Since resources are finite, all production decisions involve trade-offs

7 These assumptions will probably not be tested, but you should keep them in mind as we discuss decision-making later.


Producers must decide to make certain goods over others They must also decide on particular processes to produce these goods

In examining the production of any two goods, we find that producers can produce different combinations of goods depending on how they allocate their limited resources

Production possibilities can be depicted in a table noting what combinations of two different goods one can produce with different combinations of resources

Graphing these combinations produces the production possibilities frontier (PPF) or production possibilities curve (PPC)

This graph shows the possible combinations one can produce with available resources

Each axis of the graph represents the quantity of each good that can be produced with a given allocation of available resources

The PPF implies that increasing the production of one good requires decreasing the

production of the other

The PPF

D C

Good X

B

A

Good Y

To produce at any point on the PPF curve (such as points B and C) requires 100% efficient production and the utilization of all available resources

All points on the curve represent equally efficient production and allocation of resources

Social mores and immediate circumstances dictate which points on the curve are “better” for a specific business or nation

Points B and C, therefore, are equally efficient Producing at a point inside the PPF (such as point A) denotes inefficient production

Not all available resources are being allocated efficiently Production at a point outside the PPF (such as point D) is impossible

There are not enough resources to achieve this level of production Specialization and trade with other nations, however, can allow a nation to attain a

combination of goods outside its PPF The PPF can shift outward if more resources become available or if technology

improves, allowing for more efficient production If the PPF of an entire nation shifts outward, the shift represents economic growth The PPF can also shift outward with increases in a nation’s stock of capital goods

Remember that capital goods are used to make other goods An increase in capital goods now allows for the production of more goods later

The PPF illustrates opportunity costs and trade-offs Moving from one point to another on the curve necessarily entails giving up

something else


Going from point B to point C, for example, gains more of Good Y at the expense of Good X

The PPF will usually be bowed out from (or concave to) the origin The shape of the PPF results from increasing costs as more of one good is produced

instead of the other The reason for this shape is that certain resources are better-suited for producing

one good than another As inappropriate resources are used to produce one good, the cost of producing

that good increases Note that this increased cost includes increased opportunity costs: resources

that are less suited for the production of one good are more suited for the production of the other

Ford Mustangs and wheat, for example, require incompatible resources The PPF is linear (a straight line) if the two goods in question are perfectly

interchangeable Producing one requires the exact same resources and skills as producing the other Apples and oranges are often used as examples for this situation (see below)

A Linear PPF

Apples

Oranges

The PPF in action: guns and butter The stereotypical goods used as examples when discussing the PPF are guns and butter8

Guns represent goods produced in wartime Butter represents goods produced in peacetime

Obviously, the inputs used to produce guns are not the same as those used to produce butter9

The graph below depicts the PPF of DecaLand, our imaginary nation DecaLand is devoted to the production of two goods, and two goods only: guns and

butter At point A, nearly all available inputs are being used to produce guns

These inputs include, of course, resources that are not very well-suited for producing guns but are very good for producing butter

Dairy farmers are being employed to weld metal rather than milk cows Sacrificing just a few guns would yield a relatively large quantity of butter Conversely, we would have to sacrifice a lot of butter to get just a couple more guns

This situation illustrates the high opportunity cost that arises as we move toward the ends of the curve (near the axes)

8 Or, as my old econ teacher used to say, “guns and butters.” – Dean 9 Though I have heard that cows make good ground-to-air missiles. – Dean


At point B, inputs are split more or less evenly between guns and butter Gun factories are primarily producing guns Dairy farms are mainly producing butter

At point C, we have a situation opposite that at point A DecaLand has prioritized butter over guns Some gun factories are being used, somewhat inefficiently, to produce butter rather

than guns With this PPF, DecaLand cannot attain the combination of goods at point D on its own

Through specialization and trade, however, this point is attainable Assume, for example, that DecaLand specializes in butter10 and trades with Guns Galore

Kingdom for guns Exchange theoretically allows DecaLand to have the combination of goods

represented by point D The butter would be produced domestically and the guns would be imported

from another nation However, DecaLand’s PPF may shift outward as a result of the discovery of new

resources, an increase in the nation’s capital stock, or an improvement in technology If this new curve intersects or surpasses point D, point D is attainable The capital stock of a nation is its total pool of capital resources

Remember that capital goods are used to produce other goods This example helps illustrate the implications of the PPF in terms of opportunity cost

Economic Decision-Making Cost-benefit analysis

While the PPF shows what production combinations of goods are physically possible, actual production decisions are determined by individual values

Cost-benefit analysis is the decision-making process that guides all economic decisions Simply put, this process entails making a list of the pros and cons of a decision The costs (including opportunity costs) of producing or procuring a good are weighed

against the benefits of the next-best alternative Rational persons, firms, etc. will choose to produce or acquire goods when the benefits

of doing so outweigh the costs There are multiple types of costs that an individual must consider

An individual is ultimately concerned with the total economic cost of a good Remember: Economic Cost = Accounting Cost + Opportunity Cost

Agents also face sunk costs in making decisions

10 We are, after all, a peaceful people. – Dean

DecaLand

Guns

Butter

A

B

D

C


Sunk costs are costs incurred in the past They are, consequently, impossible to recover For example, the non-refundable registration fee for an AP test is a sunk cost

For economists, a rational entity will NOT consider sunk costs in current decisions As Stanley Jevons wrote, “Bygones are forever bygones” The registration fee for your AP test should not influence your decision

afterward of whether or not you still want to take the test Since sunk costs cannot be recovered, an agent must pay them regardless of their

decision11 Marginal analysis

Economic decisions are usually based on the margin Marginal essentially means “one more” unit of something

Marginal analysis is the study of what will happen if we change variables by small amounts Marginal analysis typically looks at single units In economics, marginal analysis typically applies to production and consumption

decisions Marginal analysis is based on incremental increases or decreases of goods currently

consumed or produced A decision on the margin is based on whether the consumption12 or production of

another unit of a good will lead to a net increase in cost or benefit In other words, marginal analysis is conducting a cost-benefit analysis for the

production or consumption of one more unit Almost all economic decisions are based on marginal analysis

Decisions on the margin are based on two factors Marginal cost is the cost incurred by producing or consuming one more unit of a

given good Marginal benefit is the benefit created by producing or consuming one additional unit

of a good For firms, these costs and benefits are normally expressed in terms of revenue For consumers, these cost and benefits are usually in terms of utility

Marginal analysis is heavily influenced by the law of diminishing marginal utility As stated above, utility is the pleasure or satisfaction an individual receives from a good

Marginal utility, therefore, is the satisfaction an individual gains from consuming one more unit of a good or service

Utility values for goods are unique for each individual Different individuals unknowingly assign different utility values for the same things

Joe may hate blue pens but love Magic Rub erasers Sally, on the other hand, may be allergic to Magic Rub erasers and violently

opposed to black pens13 Joe will assign a higher utility value to Magic Rub erasers than Sally Conversely, Sally will get more utility out of blue pens than Magic Rub erasers

To illustrate the law of diminishing marginal utility, let’s assume that Frat-Boy Frank hasn’t eaten in over a day

Frank decides that the best way to satiate his hunger is to order a fresh, piping hot cheese pizza14

11 However, recent research has shown that individuals do strongly consider sunk costs in decision-making. Whether this is an inherent criticism of economics or instead calls into question the rationality of human beings is an open question. 12 Note that the act of “consuming” a good includes purchasing it. 13 It should be illegal, what they put in those things. – Patrick


Since he’s very hungry, the first slice tastes great In other words, his marginal utility from that slice was very large His total utility at this point is equal to the marginal utility of his first slice

Total utility is the total satisfaction one has gained from a particular activity Since Frank has only had one slice of pizza, his total utility is equal to the

utility he gained from that one slice His second slice is also pretty good, but not quite as satisfying as the first

The marginal utility of the second slice is big, but not as big as the marginal utility of the last slice

His total utility increases, but it doesn’t double It increases by less than it did when he had his first slice

His third slice is decent, but it’s not as hot anymore as the first two Frank is also a little bit less hungry by now Again, his marginal utility for the third slice is less than it was for the second His total utility has increased, but not by as much

Eventually, Frank has eaten so much pizza that he can’t even bear to look at melted cheese and bread anymore15

He concludes that the marginal utility of consuming one more slice of pizza would be negative: it would decrease his total utility

Since Frank is a rational person, he decides not to eat something that will make him less satisfied than he is already

So, Frank stops eating To sum up Frank’s story, as we consume more of a single good, the marginal utility

value for the next unit consumed begins to decline Total utility still increases (although at a decreasing rate)16 until the marginal utility

value for the next unit consumed is negative Decision-making in a social context

For many goods and services, individual and social goals and utilities are very different What is best for a given society, community, etc. is not necessarily what is best for an

individual, and vice versa Individual decisions may have effects beyond the satisfaction of that individual’s wants

An externality is a cost or benefit that affects a third party not involved in the transaction or activity in question

A producer or consumer usually doesn’t factor externalities into decision-making because he or she usually doesn’t pay the costs or receive the benefits

Externalities take two forms Negative externalities occur when an individual’s (or firm’s) decision imposes some

harm on others The individual does not have to pay for this harm and, consequently, does not factor

it into his or her decision17 Negative externalities thus lead to situations that are not socially optimal For example, Tito’s Toothpaste Factory may produce pollution (a negative

externality) as a by-product of its production process When Consumer Catherine goes to the store to buy toothpaste, the price she

pays does not include the social cost of the pollution from Tito’s factory

14 Hopefully with pineapple. Mmmmmmm…. – Dean 15 In other words, he’s lost his culinary mind. – Dean 16 In calculus terms, the first derivative is positive, but the second derivative is negative. 17 Some good examples of negative externalities are second-hand smoke and pollution. – Zac


Ideally, Tito would factor the social cost of pollution into its decision-making and have his factory produce fewer tubes of toothpaste

Since Tito does not factor in this cost, however, his factory makes more tubes of toothpaste (and more pollution) than is optimal for society

Positive externalities result when an individual’s (or firm’s) decision results in positive effects for society or other individuals

Since these benefits are not realized by the individual, they are not factored into his or her decision

Positive externalities, therefore, also lead to situations that are not socially ideal They do not provide a strong enough incentive to encourage decision-makers to

do more of whatever results in the externality For example, Gardener Gary might plant a large patch of fresh roses on his front

lawn Though Gary was the only person involved in planting them, passers-by and

neighbors enjoy the roses’ sweet fragrance Their olfactory18,19 pleasure is a positive externality

Gary’s neighbors, of course, want him to plant more roses so they can enjoy even more of the scent

The positive externality (their happiness) does not, however, encourage Gary to plant more roses

Consequently, there are fewer roses planted on Gary’s lawn than is socially optimal

Unfortunately, far more decisions involve negative externalities than positive externalities

Negative externalities are reduced and positive externalities are augmented by internalizing their costs or benefits, respectively

An individual internalizes a cost when he or she pays it directly An individual internalizes a benefit when he or she enjoys it

An individual will take these costs or benefits into account if they are internalized Taxes, fines, and regulations can internalize the costs of negative externalities

These measures discourage an activity by increasing its cost To go back to our example, Tito would likely cut production of toothpaste to a

level closer to the social ideal if his factory’s pollution were taxed Subsidies, tax incentives, and other inducements can internalize some of the benefits

from positive externalities These measures encourage an activity by increasing its benefit Gardener Gary (from our example) would be more likely to plant more roses in

his garden if his neighbors all chipped in to help cover the cost of the flowers Internalizing externalities help move the individual (or firm) toward the socially optimal

level of activity Social goods are often the result of, or are realized through, collective action

Collective action is required when a common or mutual good can only be brought about by individuals working together

Since individuals pursue individual interests or have divergent interests, coordinating the actions of individuals can be difficult, leading to collective action problems

Agents broadly agree on achieving a certain goal but not always on how to attain it specifically

18 SAT Word Alert! “Olfactory” means “of or pertaining to the sense of smell.” – Lawrence 2006 19 Whoa. Did I really say that in a footnote? – Lawrence 2007


Collective action problems can be resolved by imposing costs on those who fail to cooperate or by facilitating cooperation

Positive vs. normative economics In economic analysis, there are two types of statements: positive and normative Positive economics is only concerned with “what is”

Positive economics concern only statements that can be tested for truth These statements do not necessarily have to be true, but they must be testable

In other words, they can be proved valid or invalid Positive economics does not include opinions

Example: “The unemployment rate of the United States in April 2005 was 5.2%” We could easily conduct a study to verify whether or not this figure is true

Example: “There are more women than men in California” Again, this may or may not be true We could, however, commission a study to find out Since we can prove or disprove this statement, it is a positive statement

Normative economics concerns judgments and opinions Normative statements usually concern “what should be”

Example: “In order to promote growth, the U.S. government should allow free trade with Mexico”

This statement does not express an idea that is factually testable Therefore, it is normative

Example: “If the unemployment rate hits 6%, we should increase government spending by 3%”

Though this statement involves statistics, its main idea (we should increase government spending if unemployment climbs) is an opinion, not a fact

Normative statements are often simple statements of opinion Example: “DemiDec Dean should take a vacation”

Regardless of whether or not you agree, this statement cannot be considered testable fact

The easiest way to differentiate between positive and normative statements is to look for certain normative “flags”

If a sentence contains words like “should,” “must,” or “ought,” then it is most likely normative

Some normative statements take this general structure: “if X, then we ought to do Y”

Economic Systems The three fundamental questions20

There are three basic economic questions that all societies must answer Who answers these questions determines the economic structure of a society The three questions are listed below

What to produce? How to produce? Who receives the benefits of production?

Traditional economies In traditional economies, these questions are answered by, well, traditions

20 Some economists believe there are actually four; others argue that there are five. For our purposes (and USAD tests), assume there are three. The most common fourth question is “How much to produce?”


hat and how they do

onal economies exist in the world today areas of Brazil and Indonesia, however, are home to traditional

ned economies, the state answers production and allocation questions ts for the economy to determine the supply of

of planned economies for the benefit of society as

direction

s controlled by private firms, but the government

to meet these goals by figures with absolute authority and

e former Soviet Union and communist China23

rols the means of production

luding wages) are fixed by state-controlled agencies ns (such as where one works) are determined by

ate agents are taken

ncome distribution

l over personal activity from

y rties

y low

oods

Social mores21 and generally accepted norms govern who produces wit

Basically, “We do it that way because we’ve always done it that way” Very few traditi

Some remote economies

Planned economies In plan Planned economies feature production targe

goods There are two types

In an indicative economy,22 decisions are made by groupsa whole

These groups steer the economy in a specific Democratic decision-making and institutions are often present An example was Sweden a few decades ago

In Sweden, most production wadirected this production, set goals, and offered incentives to encourage firms and individuals

In a command economy, decisions are madeno accountability

These systems are markedly more despotic Consequences for not following the directions of the state are often severe Examples include th

In a planned economy, the state either owns or cont Goods are often rationed

Individuals are allocated fixed amounts of goods Prices (inc Production, investment, and labor decisio

the state Planned economies have several benefits

Externalities are generally eliminated Costs and benefits which would be ignored by individual, priv

into consideration by central planners Price and wage controls result in a controlled i

Theoretically, this distribution should be relatively egalitarian Planned economies also have some disadvantages

Price and wage controls may also require significant contro This control is particularly necessary when the planned prices or wages differ

what they would be in a functioning market econom The only way to maintain controls is through restrictions of personal libe

Price- and wage-setting is difficult and often inaccurate Government authorities are motivated to price basic commodities ver

Doing so results in either shortages or severe rationing In either case, most people cannot procure these basic g

21 SAT Word Alert! Mores (pronounced mórays) are the traditional customs, traditions, etc. of a group. – Dean 22 You should note that USAD considers a “planned” economy equivalent to an “indicative” economy rather than an umbrella term that includes both indicative and command economies. 23 As those who studied the 2006-2007 curriculum know, China is leaning more and more toward a market economy.


s because of a lack of innovations

re intervention

es, instead of what individual

variety of consumer goods ism,

ibuted to Karl Marx and influenced most modern

odern socialist

of the Soviet Union and the introduction of market reforms in China,

ded by individual

st and profits motivate the actions of all individuals and firms ee supply and demand of goods in a market

hatever they want]”

ws ods

ls to buy them gh market forces

oduction methods, etc. are allowed to fail or go out of business ies don’t tie up scarce resources from more productive

Shortages will be discussed in more detail with price ceilings later Planning eliminates entrepreneurship as a factor of production

Profits are eliminated by price and wage controls Thus, entrepreneurial activity is effectively stifled by a lack of rewards

The society suffer Market inefficiencies result, some of which the government must remedy through

even mo Wage and price controls can eliminate individual motivation to work, also resulting in

inefficiency Resources are allocated to activities which the state valu

consumers would choose for themselves The result is a very limited

The political ideologies most frequently associated with planned economies are socialMarxism, Leninism, and Maoism

Perhaps the most influential form of planned economics is attr The most important Marxist work, which inspired

communist thought, is The Communist Manifesto (1848) This work was co-authored by Friedrich Engels Marx was not, however the first m

He was predated by the utopian socialists, including Thomas More, Robert Owen and Charles Fourier

For testing purposes, decathletes should associate socialism with indicative economies24 and communism with command economies

Since the collapse only a few “planned” economies still exist today, such as Cuba and North Korea

Market economies In free market economies, production and allocation questions are deci

economic agents interacting in free markets Self-intere

Resources are allocated based solely upon the frenvironment

Private agents control the means of production Individuals set their own production and consumption goals

The state is removed from all economic decisions This concept is known as laissez faire25

This phrase means “Leave them [businesses] do [w The state merely sets the “rules of the game”

It enforces property rights, contracts, and other la Prices are determined by the willingness and ability of firms to produce and supply go

and the willingness and ability of individua The quantity of a good demanded or supplied is also determined throu Market economies have certain benefits

Resources are efficiently allocated to profit-maximizing endeavors Inefficient industries, pr

As a result, inefficient activitactivities

Allocative efficiency prevails

24 Remember that USAD considers planned economies to be synonymous with indicative economies. 25 “Laissez faire” is the same as “Laissez passer” (“Let them [businesses] pass”).


iciency, individuals’ overall satisfaction

ew, more efficient, or

ial and economic progress c activity they desire within their means

rticularly wealth inequality

s no way to internalize them

s of their activities as long as they

e generally not completely “free”

y is free f the production or allocation

st today

arianism

Ages and

prioritized the accumulation of precious metals, or bullion

y

in macroeconomics)

d in 1776

mics

Resources are allocated to those activities that society values most What society values most is determined by what individuals demand In an economy experiencing allocative eff

cannot be increased by producing more of one good or less of another Competition allows for creative destruction

Old practices or obsolete goods are eliminated in favor of nsimply better goods which increase social welfare26

Creative destruction results in soc Individuals are free to pursue whatever economi

Decisions are not made for them Market economies also have certain disadvantages

Competition can (and usually does) create inequality, pa The distribution of wages may not be totally just Prices may be higher or lower than we think is fair

Externalities (especially negative externalities) are more prevalent in completely free markets because there i

Many activities with positive externalities are not pursued to the socially optimal level

Similarly, firms ignore the negative externalitiecontinue to make profit

Market economies ar Even in laissez-faire economies, governments still step in to enforce laws so that anarchy

does not prevail The state must always have some presence to ensure an orderly society even if the

econom Governments in market economies do NOT answer any o

questions These questions are left entirely to the market to decide

Very few (if any) pure markets exi The political ideologies or theories most often associated with market economies are

capitalism and libert Capitalism is generally seen as arising from the writings of Adam Smith in response

to mercantilism Mercantilism was a prevalent government policy throughout the Middle

the Renaissance Countries Mercantilism was characterized by heavy government intervention in the

econom Capitalism favors the use of markets to decide almost all production and allocation

questions It also admits, however, that governments have an important role to play in

providing public goods (to be discussed Smith’s An Inquiry into the Nature and Causes of the Wealth of Nations (The Wealth of

Nations, for short) was publishe It is widely considered to be the work that established capitalism and the

modern study of econo In this work, Smith proposes that an “invisible hand” guides market activities

toward an equilibrium

26 Though an important benefit, this leads to structural unemployment (discussed in macroeconomics).


omics) eal influence on the

ocates that hould have no role at all in private decision-making

market are involved in

combine the “best of both worlds”

intervene when necessary and own portions of the

monopolies

liberalism and social welfarism (or social democracy)

27 (1883-1946) Keynes’ most significant work was the General Theory of Employment, Interest,

and Money (1936)

The invisible hand represents the forces of supply and demand (discussed in microecon

We can’t see these forces, but they have a very reconomy

Government intervention merely hinders these forces Libertarianism is a more extreme form of market economics that adv

governments s Prominent libertarian thinkers include Ayn Rand and Robert Nozick

Mixed economies In mixed or mixed market economies, both the state and the

answering production and allocation questions These economies attempt to

The innovation and efficiency of free markets are included by allowing markets to operate relatively freely

The safety nets and egalitarianism of planned economies are included by allowing the government to

Both private individuals and the state participate in the economy means of production

Some areas of the economy may be reserved for the government These areas of the economy feature public

Public monopolies include services such as providing drinking water, the national postal service, and the fire department

These areas are seen as too vital to be left to market forces and the private sector With very few exceptions, all modern states feature mixed economies While the terms are not as clear-cut, the political ideologies most often associated with

mixed economies are Liberalism (in the classical sense) generally favors private enterprise over public

involvement Social welfarism, on the other hand, favors government or public involvement over

private businesses The most prominent economic figure for mixed economies is the British economist

John Maynard Keynes

27 Pronounced “canes.”


COMPARING ECONOMIC SYSTEMS28

Type of Economy Who Owns the

Means of Production?

Who Makes Economic Decisions?

Who Makes Political

Decisions?

Who Receives the Benefits of Production?

Market Economies Individual persons and firms Individuals Individuals Whoever is willing to

pay the most

Indicative Economies

The state The state If democratic, individuals

The state decides how benefits are

distributed

Command Economies

The state The state Dictators, kings, etc. The state decides how benefits are

distributed

Mixed Economies The state and individuals

Primarily individuals with some state

action Individuals

Primarily whoever is willing to pay, but the state will intervene if

necessary

Traditional Economies

Traditional bodies (e.g., the village) Traditional authorities Traditional

authorities Traditional allocations

Competition Competition is the central focus of all non-planned, modern economies Pure market economies, by definition, are founded on competition in a free marketplace

between individual producers to meet consumer demands Mixed economies manage competition in various ways

Regulation of goods and services ensures that competition does not undermine social welfare

Examples of regulation include product standards, health and safety standards, etc. Competition policy involves the regulation of the activities of firms

These policies usually work to ensure fair market conditions by regulating (and sometimes preventing) monopolies and oligopolies (more on this later)

Incentives and Individual Decision-Making Positive and negative incentives

Individuals respond to incentives in predictable ways Incentives alter the behavior of an economic agent based upon that agent’s utility values

Or, in simple terms, incentives attempt to persuade an individual (or firm) to do or not do something

All incentives change the costs and benefits of a given action Positive incentives increase the benefits an agent receives from an action

Positive incentives result in a utility gain for an individual Positive incentives cause an individual to act in a way that he otherwise would not For example, Lazy Louis is really thirsty but doesn’t feel like getting up from his

comfortable couch


He offers his younger brother, Greedy Gill, $5 to get a soda for him from the fridge

The $5 is a positive incentive to encourage Gill to do something he wouldn’t do otherwise

By offering Gill the money, Louis hopes to increase his younger brother’s utility enough that Gill will bring Louis a drink

Negative incentives29 increase the costs an agent receives from an action Negative incentives result in a utility loss for an individual They can cause an individual to not act in a way that he otherwise would choose to

without the disincentive For example, Lazy Louis’s mom, Mean Marie, might tell Louis that she’ll make

him scrub the bathroom floor the next time he tries to bribe Gill30 To avoid a loss in utility (and nasty germs), Louis might choose not to bribe

Gill into bringing him soda in the future Conversely, negative incentives can be used as threats to encourage an individual to

act in a certain way For example, Lazy Louis could tell his other brother, Weakling Wesley, that he’ll

punch Wesley in the stomach if he doesn’t bring Louis a soda31 In order to avoid a loss in utility, Wesley may comply with Louis’s request

How incentives work Incentives work by appealing to the rational self-interest of individuals Individuals will perform activities or consume goods which promote their self-interest

Positive incentives can be used to appeal to another’s self-interest Individuals will avoid activities or goods which work against their self-interest or do not

promote their self-interest as much as alternatives do Negative incentives can be used as a potential threat to another’s self-interest

Different forms of incentives Since they are based upon individual utility values, incentives can take a variety of forms

Incentives must be tailored to meet an individual’s unique utility values Monetary incentives are financial benefits or costs linked to certain activities or goods

An example of a positive monetary incentive is the $5 that Louis offered to his brother Gill

Non-monetary incentives are non-financial benefits or costs that cannot easily be reduced to monetary terms

Nonetheless, they can still invoke costs or create benefits An example of a negative non-monetary incentive is the punishment Marie used to

threaten Louis (scrubbing the bathroom floor)

Exchange and Markets Voluntary exchange

In seeking to promote or realize utility, economic agents will enter into voluntary exchange to attain desired goods

Voluntary exchange is the free choice of individuals to exchange goods via a means of exchange (such as money)

29 Negative incentives are also known as “disincentives” and “deterrents.” 30 What a nice, happy family. – Lawrence 31 Louis is an example of what we refer to in economics as a “jerk.” – Patrick


Voluntary exchange should occur whenever both parties of a potential exchange expect to gain

If either party expects to lose, they will not participate voluntarily in such an exchange Involuntary exchange

Involuntary exchange can occur in practice Involuntary exchange occurs when one (or even both) parties of an exchange do not expect

to gain from it Involuntary exchange can only occur as a result of coercion or force

This force can be from one of the two parties to the exchange or from a third party For example, airlines sometimes force passengers to “accept” travel vouchers

instead of taking a flight because there’s not enough room on the plane32 A judge forcing a defendant in a lawsuit to compensate the plaintiff would be an

example of intervention by a third party Markets

Markets operate based on the laws of supply and demand These laws will be discussed in detail in the microeconomics section

When a given activity is governed by market forces, the laws of supply and demand determine the price and allocation of resources to be exchanged

A market exists wherever and whenever two or more parties wish to make an exchange Markets include formal markets such as supermarkets and national markets such as the

entire United States economy With the advent of Internet shopping, markets don’t even have to exist in a physical

place Markets also include underground or informal markets

Selling your friend a bottle of water for a dollar constitutes a market Voluntary exchange takes place in, and is facilitated by, markets

Exchange in markets Markets require a means of exchange to exist to facilitate transactions A means of exchange allows individuals to transfer goods

Barter is a means of exchange where goods are exchanged directly for other goods Bartering requires a double coincidence of wants

In other words, each party in the exchange has to want what the other has Complex transactions become exceedingly difficult using bartering

Imagine, for example, trying to obtain all the different materials necessary to build a house using a barter system33

Barter, however, has the advantage of being immune to inflation Since there is no single, central currency, relative prices remain stable

Money is a medium of exchange which can be traded for any good or service It eliminates the requirement of a double coincidence of wants Money will be discussed in more detail in macroeconomics

A means of exchange smoothes transactions and allows markets to function more efficiently Three interpretations of markets

Classical economists believe that goods of the same quality will have the same price in a market

This idea is also known as the law of one price Businesses view markets as a collection of buying and/or selling opportunities The political or legal view is that markets are free trading zones

32 As has happened to DemiDec Dan several times. – Dean 33 You’d probably have to trade a cow for five rabbits for a hammer and box of nails…or something. – Dean


There are no restrictions placed upon exchanges

Specialization, Interdependence, and Trade Specialization

Markets and voluntary exchange allow economic agents (including nations) to specialize in producing certain goods

They then trade for the necessary goods that they don’t produce Specialization is based on the division of labor

The division of labor is the allocation of workers so that each worker is responsible for only one type of good or only one step in the production process

The division of labor allows for increased productivity Productivity is how much a worker can produce in a given time period Workers can acquire and perfect specialized skills through the division of labor,

increasing efficiency and production Workers do not have to physically move from one activity to another, saving time

Instead of each individual person providing every good he needs for himself, he can specialize in one particular good and exchange it for others

This system assumes that others are also willing to exchange the goods they produce If two people were stranded on a desert island, for example, one can specialize in

hunting and the other in fishing The two can then trade with one another so each has fish and meat Over time, the hunter will become a better hunter, and the fisher will become a

better fisher This system is far more efficient than if each were to both hunt and fish

The benefits of specialization do not apply to individuals alone They also apply to firms and even countries

Specialization may result from different factor or resource endowments The distribution of resources geographically is inherently unequal

Some nations have an abundance of minerals, others have a highly skilled workforce, and still others have a large population of potential workers

A nation’s factor endowment is its unique combination of resources Specialization and trade allow individuals and nations to compensate for unequal access

to the various factors of production Comparative advantage

Specialization and trade are fueled by the theory of comparative advantage The theory of comparative advantage was first presented by David Ricardo in The

Principles of Political Economy and Taxation (1817) Comparative advantage is founded upon the idea that any economic agent can produce at

least one good more efficiently than other goods By “more efficiently,” we really mean at a lower opportunity cost An entity should focus on producing what it produces most efficiently and then trade

with other agents to meet its other needs If an agent has an absolute advantage in a certain good, it34 can produce more of that

good than other agents can with the same quantity of resources Even an agent holding absolute advantage is better off trading with others due to

relative price Relative price is related to the PPF

34 We use the pronoun “it” here because an agent can be a person, firm, nation, or anything in between.


The relative price of one good is the amount of an alternative good foregone Relative price is essentially a specific instance of opportunity cost For example, let’s assume that we could produce 10 cars or 20 jackhammers with

the exact same resources The relative price of one car is two jackhammers Conversely, the relative price of one jackhammer is half of a car

Absolute advantage looks at relative prices between countries For example, the US produces airplanes more efficiently than China

Comparative advantage, on the other hand, looks at relative prices within countries For example, the US produces airplanes more efficiently than basketball shoes

Since every country must produce one good more efficiently than another, trade is almost always advantageous, even when one country has an absolute advantage in all goods

When looking at the goods produced by two countries, each country will always hold a comparative advantage in at least one good

When examining possibilities for trade, an individual agent should specialize in producing the good it can produce at the lowest relative price (opportunity cost)

Even if an agent has an absolute advantage in all goods, it is still better off focusing on doing what it does best and trading this good to meet its other needs

Similarly, even if an agent is dreadful in producing all goods, it will still be least dreadful in producing something

It should specialize in this one good When relative prices for goods between any two agents are equal, the two should not trade

No gains can be made When the relative prices for goods differ, agents should always specialize in the good for

which they have the lowest opportunity cost to gain efficiencies in production and then trade

Absolute and comparative advantages will be discussed in more detail in the international trade section

Positive- and zero-sum games A positive-sum game is a situation in which all parties can benefit

Improving the welfare of one agent does not mean that another automatically loses out Specialization and trade are a positive-sum game

A zero-sum game is a situation in which the improvement in the position of one agent means that another will have to lose out

Free trade and specialization The gains from specialization and trade are best achieved through free trade Individual agents can only specialize and become more efficient or productive when they

know they can trade for the other goods they need later If trade is restricted, then individual agents won’t be able to specialize as well or at all

They can’t be sure that they’ll be able to trade in the future to satisfy all of their wants

Miscellaneous Basic Economic Concepts35 Ceteris paribus

When economic analysis seeks to isolate a single factor, all other factors are assumed to be ceteris paribus36

35 The economics outline includes some other topics about international trade here. These topics have been relocated to p. 132 (in the International Trade and Economic Development section).


Ceteris paribus is Latin for “all other things constant” or “equal” As a social science, economics involves a huge array of variables Economists assume that all other variables are held constant in an effort to isolate matters

of interest37 However, the consequence of doing so is that analyses are somewhat less realistic

Different time frames Time frames in economics are based upon the ability of economic agents, primarily firms, to

vary their use of the factors of production Time frames are defined by what, or how many, factors are fixed and how many are variable The short run is the amount of time in which some factors of production (or factors of

anything) are fixed For example, a firm does not have enough time to build a new factory in the short run

It can, however, hire more workers or increase production In the long run, everything is variable38

All factors of production can be manipulated The firm in the above example can build and open a new factory

Fallacies As we begin to examine micro- and macroeconomics, we must remember that the

principles of one do not necessarily apply to the other The fallacy of composition points out that what is true for the parts is not necessarily

true for the whole We must remember that what may be best for a firm or individual may not be a good

idea for the economy as a whole The fallacy of division, in contrast, reminds us that what is true for the whole is not

necessarily true for the parts In other words, what may be best for a nation or aggregate economy may be less than

ideal for an individual economic agent

36 Remember the economist’s boat… – Patrick 37 This method is analogous to conducting a controlled experiment with one variable. 38 Or, as Keynes rather spitefully put it, “In the long run, we’re all dead.” – Lawrence


MICROECONOMICS POWER PREVIEW POWER NOTES

This section covers microeconomics. Microeconomics focuses on the behavior of individual economic agents, such as consumers and firms (businesses), and how these agents interact in markets.

30% of the exam (15 questions) will focus on microeconomics

11 questions from the USAD practice test are on this section


Microeconomic Basics Overview of microeconomics

Microeconomics focuses on the economic decisions of individual agents Microeconomics is concerned with individual consumers, groups of consumers, and

producers Businesses (usually producers) are referred to as “firms”

Microeconomics focuses on the choices of individual decision-makers and the reasons underlying these choices

Microeconomics also discusses the allocation of scarce resources among possible uses Microeconomics specifically involves the determination of price through the interacting

behavior of economic agents The behavior of individuals is governed by utility

Consumers seek to maximize utility The behavior of firms is governed by profit

Firms seek to maximize their profits Microeconomics and markets

Microeconomics examines the behavior of individual consumers and firms in markets Markets exist when buyers and sellers interact to participate in voluntary exchange

Consumers, or buyers, demand goods Firms, or suppliers, supply goods

Interaction between firms and consumers creates a market Markets function through, and because of, prices

Prices provide a common, standard measurement for valuing goods and making exchanges

When prices do not formally exist, individuals must barter for goods Barter is inefficient because a double coincidence of wants must exist for exchange

to take place Each party in an exchange must have something that the other wants

Prices provide a means of comparing otherwise incomparable goods Compare the value of one good in terms of another good is difficult

How many apples is an orange worth? How many oranges is a hammer worth?

Prices allow for uniform comparisons of goods Consumers compare prices to individual utility values

Using this comparison, they can decide whether or not a good is worth buying Price comparison also makes it easier for producers to make production decisions


Producers can compare the price for which a good will sell to the cost of producing

it Prices allow producers to calculate expected profits Without prices, producers would be unable to plan production decisions in advance

Markets and prices are governed by the laws of supply and demand

Types of Firms Overview

In economics, there are three basic organizational structures for firms The first is the proprietorship

It is owned and controlled by one individual The second is the partnership

It is owned and controlled by two or more individuals The third is the corporation

It is owned and controlled by stockholders and controlled by a board of directors Proprietorships

A proprietorship is owned by only one individual While proprietorships only account for about 5% of business sales annually, they make

up about 70% of all firms in the US Proprietorships have several advantages

They are very easy to form and dissolve Decision-making is very easy because the owner makes all decisions Communication between employees and the owner is very direct Profit is only taxed once

This tax is in the form of an income tax on the owner There is no corporate tax (discussed below)

The owner has a high incentive to make his business profitable since all profits go directly to him or her

Proprietorships also have some disadvantages Because there is only one owner, proprietorships often only have limited financial

resources As a result, proprietorships do not usually produce a wide variety of products

A small budget limits product diversification The owner is also 100% liable for anything that happens to his or her business

Any losses will come directly out of his or her personal assets If someone sues the business, the owner is responsible for taking on the lawsuit

and compensating the plaintiff (if the owner loses the suit, of course) As a result, proprietorships often have high insurance costs

Examples of proprietorships include most small, local businesses Partnerships

Partnerships are owned by two or more individuals While partnerships only account for about 5% of business sales annually, they make up

about 15% of all firms Partnerships have several advantages

They have more human and financial resources than proprietorships More resources allow for more product diversification

Profit is only taxed once This tax is the income tax of the owners There is no corporate tax


Because there are just a few owners, these owners have a big incentive to make their business profitable

Partnerships have a few disadvantages They are slightly more difficult to form and dissolve than are proprietorships The communication between employees and owners and among owners is not as

direct as it is in proprietorships Decision-making is slightly more complicated in partnerships because there is more

than one person in charge The owners still have full liability for their company Each partner is responsible for the acts of his or her other partner(s)

Examples include many professional firms, such as law firms and medical practices39 Corporations

Corporations are owned by stockholders Stocks will be discussed in the “Stocks and bonds” section below

While they only make up about 15% of firms, corporations are responsible for about 90% of sales annually

Thus, corporations are responsible for a large economic impact, especially relative to how many exist

Corporations have several advantages Of the three types of firms, corporations have the most financial resources due to

the sale of stocks and bonds As a result, corporations are free to develop a very diversified product line

Stockholders have only limited liability An individual’s liability is determined by the number of stocks he or she owns The corporation itself is a separate legal entity

Corporations also have some disadvantages Decision-making is difficult and extremely complex

A board of directors usually controls a corporation These directors have to vote on courses of action Decisions can take a long time

There is very little direct communication between management and employees Profit is taxed at two levels

The first is the income tax of the stockholders The income of these stockholders includes the dividends they receive from

the corporation These dividends are taxed along with the rest of the individuals’ income

The second is in the corporate profit tax The corporate profit tax is, well, a tax on a corporation’s profits Corporations are considered separate legal entities—non-human individuals

in the legal system Like regular individuals, corporations must pay an income tax For corporations, this “income tax” is the corporate profit tax

Corporations are also subject to the principal-agent problem In this case, the “principals” are the company’s shareholders The agents are the company’s managers Because of the nature of corporations, managers often make decisions with their

own benefit in mind rather than the benefit of the company CEOs, for example, might give themselves huge raises

39 My dad’s law firm is a partnership. My mom works in an accounting firm that is also a partnership. – Dean


Other times, managers embezzle from their own company

When a corporation makes profit, it has two options The first option is to distribute its profit in the form of dividends

A dividend is a share of profit paid out to stockholders The second option is to keep the profit as retained earnings

Retained earnings are also known as undistributed profit A company that keeps retained earnings usually does so to invest in new

opportunities and technology Basically, it uses the extra money to promote growth

Examples of corporations include Burger King, Pepsi, and WalMart Stocks and bonds

Corporations can sell stocks and bonds to raise money for the company’s operation A stock is a legal document of ownership

Every stockholder in a company legally owns part of that company There are two types of stocks

The first is common stock Those who own common stock have a say in how the company is run

When important issues are discussed, each share of stock entitles its owner to one vote

Of course, those who own more shares have more votes The second is preferred stock

Those who own preferred stock do not have a vote in the company They do, however, have priority over owners of common stock in receiving

company dividends There are several motivations to buy stock

The price of the stock may go up The owner can then sell the stock and make a profit

Shareholders often receive dividends from the company The Initial Public Offering (IPO) price is the price of a stock when it first goes

on the market Each stock also has a P/E ratio

This is a ratio of the price (P) of a stock to its earnings (E) or dividends per share The P/E ratio tells stockholders how long, at the current earnings rate, it will

take for them to make back the money they spent to buy the stock Let’s assume, for example, a share of stock in Calvin’s Corporation costs $20

The earnings on each share per year are $2 The P/E ratio, then, is 20/2 = 10

It will take 10 years for a stockholder to make back the money he or she spent to buy the stock

The P/E ratio assumes, of course, that the earnings of the stock remain constant The P/E ratio, therefore, is only a projection, not an absolute certainty

A bond is a promissory note, or I.O.U. When an individual buys a bond, the company promises to repay the individual the

amount of the bond plus some interest in a certain period of time The amount of the bond itself is called the principal Investor Inessa, for example, could buy a $500 bond from a company

The company promises her, in return, that it will pay back the $500 plus 4% in interest when the bond comes due in six years

If a company goes bankrupt, however, bondholders may or may not get their money back


Bonds are rated in safety from AAA to DDD These ratings relate the risk of buying a bond from a certain company “AAA” means that the bond is very safe “DDD” means the bond is extremely risky

There are several motivations to buy bonds Buying a bond forces the bondholder to save money

He or she cannot use the money spent on the bond until the bond comes due (is paid back) later

Bondholders gain interest from owning the bond once it comes due Corporation dividends are paid out in a specific order

Bondholders get dividends first, followed by preferred stockholders, and, lastly, common stockholders

Mergers A merger occurs when two or more businesses unite under the same ownership

One can buy the other or the two can simply combine (merge) Mergers fall into three categories: horizontal, vertical, and conglomerate

A horizontal merger occurs when two companies at the same stage of production merge to eliminate competition

For example, McDonald’s buying Burger King would be a horizontal merger These two companies are at the same stage of fast-food production

A vertical merger occurs when two companies at different stages of production of the same product merge

For example, McDonald’s buys a meat processing company Meat processing companies sell their output to McDonald’s and other companies

Therefore, they are all involved in the production of the same product, only at different phases

A conglomerate merger occurs when two totally unrelated companies merge For example, McDonald’s and Sony merge together

The Celler-Kefauver Act (1950) prohibited any type of merger that gave the merging firms an unfair advantage in the marketplace

A merger which creates an “unfair advantage” is one which creates a monopoly

Supply and Demand40 Supply

The study of supply is sometimes referred to as the theory of the firm Supply is the quantity of a good or service that producers are willing and able to produce

at any given price The quantity supplied of a good is the amount of a good supplied at a specific price

Price and quantity supplied are directly or positively related The quantity supplied is a point on the supply curve while supply refers to the entire

supply curve41 The law of supply governs changes in quantity supplied

The law of supply reflects the direct42 relationship between price and quantity supplied: as the price of a good increases, the quantity supplied of a good increases

40 If you encounter a supply and demand question on an exam, I HIGHLY recommend that you graph it (using the information to follow). Doing so will help you visualize what is being asked and come to the correct answer. 41 This is a very important distinction. Very important. Even more important than carrying a towel. – Joe 42 Note that the term “direct” does not mean there is a 1:1 relationship between quantity supplied and price. Supply curves are often not straight lines: changes in price do not always result in a proportional change in quantity supplied.


Higher prices allow for higher profits at higher levels of production

Subsequently, firms already producing the good will produce more of it Economically speaking, more firms are willing and able to supply more goods at

higher prices In the long run, higher prices will also attract new firms or producers to enter the

market, which increases total market supply The short run is too brief a time period for new producers to enter the market

Supply can be represented by a table called a supply schedule The supply schedule lists the number of goods producers are willing to supply at each

price The prices are unit prices, which represent the price of each good supplied

Below is an example of a supply schedule for William’s Widgets

Supply Schedule for William’s Widgets

Price per Widget $5 $10 $15 $20 $25

Quantity Supplied 1 3 7 10 13

Supply is represented visually by the supply curve Supply is graphed with price located on the vertical axis and quantity supplied on the

horizontal axis The supply curve slopes upward: the slope of the curve is positive

The supply curve slopes upward because producers are more willing to supply a good at higher prices

Thus, the quantity supplied increases as price increases A change in quantity supplied is represented by a movement along the supply curve

A movement along the curve is from one point to another on the curve A change in supply is represented by a shift of the entire supply curve

A shift in the supply curve means that the quantity supplied of a good at all prices changes

An inward shift (left, or toward the origin) means that the quantity supplied at any given price decreases

An outward shift (right, or away from the origin) means that the quantity supplied at any given price increases43

43 Economists generally use the terms “left” and “right” to describe decreases and increases in supply, respectively. Be careful not to use “up” and “down”: a shift upward in the supply curve actually represents a decrease in supply. This gets really confusing. Just stick to left and right.


The Supply Curve

Price

Quantity Supplied

Several factors can cause a shift in the supply curve

If the cost of the factors of production increase or decrease, the supply curve will shift to the left or right, respectively

If the price of inputs (the factors of production) increase, then the cost of producing the final good also increases

If the price of inputs decreases, then firms are willing to produce more goods at existing prices, pushing the supply curve outward

If technological progress occurs, the supply curve will shift A breakthrough in productive technology will decrease the cost of producing a

good, shifting supply to the right Firms may expect or anticipate a change in price

An expected decrease in the price of a good will lead firms to produce more now so they can sell the good at the current higher price

Thus, this expectation will cause the supply curve to shift to the right An expected increase in prices will lead firms to produce less now so they can wait

for the higher prices Thus, this expectation will cause the supply curve to shift to the left

A change in the number of firms supplying a good can cause a shift in the supply curve If the number of firms supplying a good increases, the supply curve will shift to the

right But if the number of firms supplying a good decreases, the supply curve will shift to

the left Government regulations can also affects supply

Taxes on the firm or its product reduce supply and shift it to the left Regulations also reduce supply and shift the curve to the left Subsidies are monetary incentives given by the government

Subsidies increase supply and shift the curve to the right Increases or decreases in the price of other goods can also result in a shift in the curve

This concept is best explained with an example Hannah’s Hamburger and Hotdog Hut sells, quite creatively, hamburgers and

hotdogs If the price of hotdogs increases, Hannah will concentrate more on hotdogs than

on hamburgers in order to gain more profit The supply curve for hamburgers will shift to the left Note that the supply curve for hotdogs does NOT shift because only the

price of hotdogs has changed


If the price of hotdogs decreases, Hannah will concentrate more on hamburgers

than on hotdogs in order to make more profit The supply curve for hamburgers will shift to the right Note that the supply curve for hotdogs does NOT shift because only the

price of hotdogs has changed Recall that a change in the price of a good only leads a movement along the supply curve

for that good, not a shift in the curve itself When dealing with these factors, ceteris paribus is in effect

If a test question asks what happens to supply when a technological advance occurs, for example, remember to assume that all other factors (number of firms, price of inputs, etc.) are constant

Movement Along the Supply Curve

Just because a firm supplies a good does not necessarily mean that good is sold

Supply, therefore, can also be referred to as planned supply Planned supply is what firms plan to supply in the market, which is not necessarily the

same as what consumers will buy At a given price, firms will supply as many goods as it is profitable to do so

Graphically, the point on the supply curve corresponding to the price represents this quantity

However, not all goods supplied may be bought The quantity supplied may not be the same as the quantity sold

Planned supply equals consumed (purchased) supply when the market is at equilibrium Equilibrium occurs when the quantity supplied equals the quantity demanded

Supply of a good can be elastic or inelastic, depending upon the time frame in which a firm makes its decisions

Elasticity is the sensitivity of one quantity to changes in another Elasticity is calculated by dividing the percentage change in the dependent variable by

the percentage change in the independent variable % Change in Dependent Variable

Elasticity% Change in Independent Variable

=

One can have elasticity of anything with respect to anything else For supply, elasticity measures how sensitive quantity supplied is to changes in price Ideally, firms will always change quantity supplied with changes in price In practice, however, firms are not always able to do so immediately

In the short run, firms will have already made their production decisions In these cases, firms will be unable to change the quantity supplied much, if at all,

to respond to changes in price

Price

Quantity Supplied

Shift in the Supply Curve

Price

Quantity Supplied


In the short run, the quantity supplied is often inelastic, or not very responsive

to changes in price In the long run, firms are able to plan all of their production decisions

Firms can change their decisions to meet real or expected changes in price In the long run, the quantity supplied is elastic, or very responsive to changes in

price Demand

The study of demand is sometimes referred to as the theory of the consumer Demand is the willingness and ability of consumers to purchase a good at any given price The quantity demanded is the amount of a good demanded at a specific price

The quantity demanded is a point on the demand curve while demand refers to the entire curve (see below)

The law of demand determines changes in quantity demanded with respect to price The law of demand states that as the price of a good increases, the quantity demanded of

that good decreases The law of demand indicates an inverse or negative relationship between quantity

demanded and price Basically, as one goes up, the other goes down

As the price of a good increases, consumers cannot afford to consume more Consumers will seek alternative goods instead Additionally, most consumers will not pay above a certain price for a specific good

This price is determined by the individual’s unique utility values When the price of a good decreases, the quantity demanded of a good increases

In other words, more consumers are willing and able to purchase more of the good as prices fall

Consumers can afford to consume more of the good Consumers will consume this good instead of an alternative good

Also, the lower price may fall within more consumers’ acceptable price range for that good

Demand can be represented by a table known as a demand schedule The demand schedule lists the number of goods demanded by consumers at each price

As with supply, prices are unit prices, or the price for one unit of that good

Demand Schedule for William’s Widgets

Price per Widget $5 $10 $15 $20 $25

Quantity Demanded 15 12 7 4 2

Demand can be represented visually by the demand curve The demand curve is plotted on a plane with price on the vertical axis and quantity

demanded on the horizontal axis The demand curve is a downward-sloping curve

The slope of the demand curve is negative The negative slope represents the inverse relationship between quantity demanded

and price Two factors explain the curve’s downward slope

The substitution effect occurs because, as the price of one good increases, consumers will purchase a different (but comparable) good instead

Consequently, the quantity demanded decreases as price increases (and vice versa)


The income effect occurs because, as the price of one good increases,

consumers can get fewer units of that good with the same amount of money As a result, the quantity demanded decreases as price increases (and vice

versa) Movement along the demand curve shows a change in quantity demanded

As with supply, a change in the price of a good only causes a movement along the demand curve for that good

It does NOT cause the demand curve itself to shift When demand changes, the entire demand curve shifts

A shift represents a change in the quantity demanded at all prices An inward shift (to the left or toward the origin) means that the quantity demanded

at all prices has decreased An outward shift (to the right or away from the origin) means that the quantity

demanded at all prices has increased

Several factors can cause the demand curve to shift

A change in the income of consumers will cause a shift The direction of the shift depends on the type of good in question There are two basic type of goods: normal goods and inferior goods

As a consumer’s income increases, he will buy more normal goods and fewer inferior goods

For example, new cars are normal goods Used cares, on the other hand, are inferior goods

If Car-Crazy Carmen doesn’t have very much money and decides to buy a car, she’ll probably get a used car rather than a new one

If Carmen gets a raise and starts doing a little better financially, she’ll be more likely to buy a new car

In other words, consumers prefer to buy normal goods over inferior goods if they have the income to do so

For normal goods, an increase in consumer income will lead to an increase in demand

The demand curve will shift to the right For inferior goods, an increase in income will lead to a decrease in demand

The demand curve will shift to the left Luxury goods comprise a subset of normal goods

They are very expensive and certainly not necessities As consumer income increases, consumers will spend a larger portion of their

incomes on luxury goods (such as yachts, jewelry, etc.) Those in the lower rungs of the economic ladder will spend very little money on

luxury goods

Price

The Demand Curve

Quantity Demanded


Demand for a good can change because of a change in the price of a substitute good Substitute goods are goods that consumers will buy in place of another

Two substitute goods are usually of about the same quality Switching from one to another usually won’t result in a large decrease or

increase in satisfaction (utility) A classic example is Pepsi and Coke44 Hamburgers and hotdogs are also usually considered substitutes45

To illustrate the relationship between substitute goods, let’s assume that Sprite and Mountain Dew are substitutes

If the price of Sprite increases, the quantity demanded of Sprite will decrease in accordance with the law of demand

To avoid the higher price of Sprite, many consumers will switch to Mountain Dew instead because Mountain Dew is, to them, just as satisfying

As a result, the demand of Mountain Dew increases, and its demand curve shifts to the right

Conversely, a decrease in the price of Sprite will result in a decrease in the demand of Mountain Dew

Many consumers will shift from Mountain Dew to Sprite in order to take advantage of the lower price

The demand curve for Mountain Dew will shift to the left The quantity demanded of Sprite will increase, but its demand curve will

NOT shift Demand for a good can change because of a change in the price of a complementary

good Complementary goods are goods which are closely related to or used with each

other Purchasing one usually involves purchasing the other A classic example is peanut butter and jelly

To illustrate the relationship between complementary goods, let’s assume that pens and Wite-Out are complementary goods

If the price of Wite-Out increases, the quantity demanded of Wite-Out will decrease in accordance with the law of demand

Because people usually buy Wite-Out and pens together, fewer people will buy pens

As a result, the demand for pens will decrease, and the demand curve for pens will shift to the left

Conversely, if the price of Wite-Out decreases, the quantity demanded of Wite-Out will increase in accordance with the law of demand

As the quantity demanded of Wite-Out increases, the demand for pens will increase as well

Since only price has changed, the demand for Wite-Out does NOT change: quantity demanded changes46

Changes in consumer preferences or tastes can effect demand Preferences reflect the utility values that consumers assign to goods Essentially, a good that is preferred is popular or “in style”

44 For me, anyways. – Dean 45 What one person considers substitute goods may not be substitutes for another person. Some people, for example, drink Pepsi but hate Coke. Substitutes in general are determined by social and cultural norms. 46 This may seem confusing at first, but this an EXTREMELY important concept that is frequently tested.


An increase in the popularity of Fossil watches, for example, will lead to an increase

in demand The demand curve for Fossil watches will shift to the right

A shift of preferences away from Abercrombie jeans, for example, will lead to a decrease in demand

The demand curve for Abercrombie jeans will shift to the left Changes in consumer expectations can also effect demand

If consumers expect a newer, better good to emerge in the near future, the demand for the current good will decrease

If consumers expect a decrease in the price of a good in the future, the current demand for that good will decrease

Consumers are waiting for the lower price If consumers expect an increase in the price of a good in the future, they will

demand more now in order to take advantage of the price while it lasts Changes in the sheer number of consumers may also effect demand

If the number of consumers drops, then the demand for a good will decrease If the number of consumers increases, the demand for a good will increase

As with supply, remember the of ceteris paribus If a question asks what happens to demand when the price of a substitute good

increases, for example, remember that all other factors (number of demanders, price of complements, etc.) remain constant

Shift in the Demand Curve Movement Along the Demand Curve

The demand for a good can be either elastic or inelastic

Elasticity, as noted above, is the sensitivity of one thing to changes in another Elasticity of demand measures how sensitive the quantity demanded of one good is to

changes in price Demand-price elasticity is equal to the percent change in the quantity demanded divided

by the percent change in price: change in QD QD QD QD

E change in P P P P

1 0

1 0 0

% (% (

0))

− ÷= =

− ÷

In the above equation, “E” is called the elasticity coefficient, which is just a numerical representation of a curve’s elasticity

The above equation is called the “point” formula for calculating elasticity

Quantity Demanded

Price Price

Quantity Demanded


The following equation is called the “arc” or “midpoint" formula

change in QD) QD QD(average QD) QD QD

E P Pchange in P)P P(average P)

1 0

1 0

1 0

1 0

(( )

(( ) 2

2−

+ ÷= = −+ ÷

This equation is slightly more accurate than the point formula Looking at the demand curve, we see that demand-price elasticity is inversely related

to the slope of the curve As a result, a steeper line has a lower elasticity A flatter line has a higher elasticity

If demand elasticity (or elasticity coefficient) is less than one, the good is said to be price-inelastic (or just inelastic)

A price-inelastic good is not very sensitive to changes in price The percentage change in quantity demanded will be less than the percentage

change in price As a result, increasing the price of an inelastic good will lead to an increase in the

total revenue received by the producer Total revenue = (total units sold)(price of each unit)

Goods which are price-inelastic are generally necessities such as basic foodstuffs (like salt) or clothes

One has to consume these regardless of income These goods generally do not have many substitutes: if price increases,

consumers don’t have much of a choice but to keep buying the good anyway When their price increases, consumers don’t have much of a choice but to

keep buying them anyway Graphically, an inelastic curve is very steep

If demand elasticity is equal to zero, the good is perfectly price-inelastic Any change in price will not result in any change in quantity demanded Graphically, a perfectly inelastic demand curve is vertical47 This label is purely theoretical Even for absolute necessities (such as insulin for diabetics), price will eventually

become prohibitively high If demand elasticity is greater than one, a good is price-elastic (or just elastic)

An elastic good is very sensitive to changes in price The percentage change in quantity demanded will be greater than the percentage

change in price Increasing the price of a good will lead to a decrease in total revenue

Goods which are price-elastic are generally goods which are luxuries or which have a number of readily available substitutes

If their price increases, consumers can either choose to stop purchasing the item or switch to an alternative with a lower price

If the price of Ferraris goes up, for example, consumers can choose not to buy a luxury car or switch to Porsches instead

Graphically, an elastic demand curve is very flat If demand elasticity equals infinity, a good is perfectly price-elastic

Any change in price will result in an infinite change in the quantity demanded No goods will be demanded except at one given price

47 One way to remember this is that a vertical line looks like an “i,” the first letter of “inelastic.”


Like perfectly inelastic goods, perfectly elastic goods are purely theoretical

If elasticity is equal to 1, a good is said to be unit elastic The percentage change in quantity demanded will be equal to the percentage change

in price Increasing or decreasing the price of a good will not have any effect on total revenue

The elasticity of a good is also related to time In the short run, individuals have less time to look for alternative goods

As a result, goods are generally more inelastic in the short run In the long run, individuals can either find alternatives or change their lifestyles to

adjust to changes in price Consequently, goods are generally more elastic in the long run

For example, gas is fairly inelastic in the short run If the price of gas increases, people have no choice but to fill up They can drive a little less and carpool a little more, but their overall demand for

gas does not change dramatically In the long run, however, consumers can buy hybrid cars, switch to a job closer to

home, etc.

Cross-price elasticity (Ec) examines the effects a change in the price of one good has on

the demand for another good x

cy

change in QD )E

change in P )(%(%

=

QDx is the quantity demanded of good X Py is the price of good Y If Ec is greater than zero (positive), then the goods are probably substitutes

An increase in the price of the second good (good Y) leads to an increase in the demand of the first good (good X)

Price

Quantity Demanded

Perfectly Inelastic

Price

Perfectly Elastic

Quantity Demanded

Price

Quantity Demanded

Inelastic

Price

Elastic

Price

Quantity Demanded

Unit Elastic

Quantity Demanded


cond good (good Y) leads to a decrease in the

cross-price elasticity coefficient, the stronger the

ample, a coefficient of 5.7 indicates a stronger relationship than a coefficient

e

examines the effects a change in overall consumer income has on the demand for a good

If Ec is less than zero (negative), then the goods are probably complements An increase in the price of the se

demand of the first good (good X) If Ec is equal to (or close to) zero, then the two goods are probably unrelated The greater the absolute value of the

relationship between the two goods For ex

of 2.3 A coefficient of -3.5 implies a stronger relationship than -1.2 A coefficient of -3.5 suggests a stronger relationship than 2.3

Though the negative coefficient suggests complement goods and the positivcoefficient suggests substitute goods, the former shows a stronger relationship

Income elasticity (EI)

I(% change in QD)

E change in income)(%

=

s, then E is positive

reases (or vice versa), then EI is negative

Income and quantity demanded vary in the opposite direction

If quantity demanded increases as income increase I

The good in question, then, is a normal good Income and quantity demanded vary in the same direction

If quantity demanded increases as income dec The good in question is an inferior good

ELASTICITY

Number Range Name R l Representation Other Notes elation to Tota

Revenue (TR) Graphical

E = 0 Perfectly inelastic in price lein TR

Perfectly vertical line Purely theoretical

Increase in price leads to increase in TR; decrease

ads to decrease

E < 1 Inelastic in price lein TR

Steep line

A

goods are more inelastic

Increase in price leads to increase in TR; decrease

ads to decrease

pplies to goods thatare necessities and goods that have few available substitutes;

in the short run

E = 1 Unit elastic Chan no effect on TR

Line w pe of 1 or -1 proport

ge in price has ith a sloChanges in quantity

demanded are exactly ional to changes in price

E > 1 Elastic in price lein TR

Relatively flat line t

more elastic in the long run

Increase in price leads to decrease in TR; decrease

ads to increase

Applies to goods that are luxuries and goods hat have many availablesubstitutes; goods are

E = ∞ Perfectly elastic Chan s to loss of all TR

Perfectly horizontal line Purely theoretical ge in price lead


Market Equilibrium Overview of equilibrium

Supply and demand represent two sides of the same market When plotted together in the same graph, the intersection of the market supply and market

demand curves shows the point of market equilibrium At this price and quantity, all goods which are supplied will be consumed Similarly, all goods that are demanded will be supplied There are two aspects to the market equilibrium

The exchange price or equilibrium price is the price for which goods are exchanged at market equilibrium

The equilibrium price is also known as the market clearing price This definition comes from the fact that, at equilibrium, all interested buyers can

buy and all interested sellers can sell As a result, the market “clears” because no goods are left over

The exchange quantity or equilibrium quantity is the quantity of goods exchanged at market equilibrium

Prices are signals through which buyers and sellers communicate By buying a product at the market price, you are essentially telling (“signaling”) the seller

that the price you’ve paid is acceptable A refusal to buy signals that the price is too high In fact, prices are the means through which Smith’s “invisible hand” functions

Market equilibrium and shifts Shifts in supply and demand have varying effects on market equilibrium When only one curve (either supply or demand) shifts, the effects of such a shift on the

exchange price and exchange quantity can be determined If supply increases but demand remains constant, the exchange price will fall but the

exchange quantity will rise48 If demand increases but supply remains constant, both the exchange price and the

exchange quantity will rise If both curves shift at the same time, either market price or quantity (but not both) will be

ambiguous If supply and demand shift in the same direction, then the change in exchange price is

ambiguous If supply and demand both increase, exchange quantity will increase, but the change

in the exchange price is uncertain If supply and demand both decrease, exchange quantity will decrease, but the effect

on exchange price is indeterminate If supply and demand shift in opposite directions, the change in exchange quantity will be

ambiguous If supply increases but demand decreases, then exchange price will decrease, but the

change in exchange quantity is uncertain If supply decreases but demand increases, then the exchange price will increase, but

exchange quantity is ambiguous To resolve the ambiguity, we must calculate how much each curve is shifting

This calculation, however, is beyond the scope of basic microeconomics, and we will not discuss it here

48 Go ahead: draw it! – Dean


C

In the graph above, line A represents the original demand curve, line C the original supply

curve, and point 1 the original market equilibrium If demand shifts from A to B and supply (line C) remains the same, then the new market

equilibrium is at point 2 Price and quantity have both increased

If supply shifts from C to D while demand (line A) remains the same, then the new market equilibrium is point 3

Price has decreased while quantity has increased If both curves shift (demand from A to B and supply from C to D), then the new market

equilibrium is point 4 Quantity has increased, but price is ambiguous

In our model, it may look as though price has increased Shifting the supply and demand curves by different amounts, however, would

result in higher or lower prices If we do not know the magnitudes of the shifts, therefore, the change in price is

ambiguous Rather than memorize all the different combinations, draw one graph for each shift if you

see a question which presents you with two shifts In other words, draw one graph in which you shift only demand and one in which you

shift only supply Then analyze the effect on quantity and price in each graph One of the two will change in the same direction in both graphs while the other will

change in opposite directions The one which changes in opposite directions is indeterminate

Shortages and surpluses If the price of a good is anything other than the market-clearing price, a surplus or shortage

will result If the price of a good is below the market-clearing price, a shortage results

Quantity demanded increases because consumers are willing to purchase more of a good at the lower price

Quantity supplied will decrease because firms are unwilling to supply as much of a good at the lower price

The result is that some consumers who would be willing to buy the good at the current price are unable to do so because firms will not supply the quantity demanded at that price

In other words, quantity demanded is greater than quantity supplied

D 3

2

Market Equilibrium

1

A B

4

Price

Quantity


If the price of a good is higher than the market-clearing price, a surplus results Quantity demanded decreases because some consumers are unwilling to purchase the

good at the higher price Quantity supplied will increase because firms will gladly supply more of a good at the

higher price The result is that firms who would be willing to sell at the current price are unable to

do so because consumers will not consume the quantity supplied at that price In other words, quantity supplied is greater than quantity demanded

In a free market governed only by supply and demand, surpluses and shortages will never develop (except in the very short run)

Consumers and firms in a free market interact to set a new market-clearing price to deal with changes in circumstances

If surpluses occur, firms will leave the market as they are unable to sell their goods to recoup costs

This exodus of firms will lower supply until a new market-clearing price is reached If shortages occur, firms will enter the market to meet consumer demand, which will

increase supply Note that these changes depend upon prices being flexible

So long as prices can respond to changes in supply and demand, surpluses and shortages will eventually be eliminated and a new equilibrium price will be reached

Surpluses and shortages can develop and persist if prices are fixed Governments often set prices at certain levels to achieve various goals If a price ceiling, or maximum price, is set below the market-clearing price, a shortage

will result Consumers will demand more than firms are willing to supply Classic examples include rent controls and price controls on basic necessities The unsatisfied consumer demand can create informal or black markets for desired

goods, where prices will more accurately reflect demand A price ceiling placed above the equilibrium price will have no effect on the market

Price Ceiling

If a price floor, or minimum price, is set above the market clearing price, a surplus will

result49 If a price floor is enacted, firms will supply more of a good than consumers are

willing or want to purchase

Price Ceiling

49 Remember that the “house of economics” is always upside-down: the floor is on top and the ceiling is on bottom.

Price

Shortage

QS QD Quantity


Examples of price floors include price supports for agricultural commodities and

minimum wages In the labor market, firms are the consumers and laborers are the suppliers

Minimum wage results in a surplus of labor, also known as unemployment This surplus is particularly large at wage levels above minimum wage: most

employers won’t pay higher than minimum wage if they don’t have to A price floor placed below the equilibrium price will have no effect on the market

Because price ceilings and floors prevent the market from reaching equilibrium,

many economist argue that markets function most efficiently when left alone Consumer and producer surpluses

In looking at a demand curve, one can see that some consumers would willingly pay more than the equilibrium price for the good in question

The consumer surplus is how much above its market price consumers value a good

The extra utility gained by these consumers in paying a lower price for something for which they would happily pay more is the consumer surplus

The consumer surplus can be calculated by determining the area of the shape (often triangle) formed by the demand curve, the vertical axis, and a horizontal line extending from the current market price to the vertical axis

In the graph below, the area of triangle A is the consumer surplus

A

B

Price

Quantity

Demand

Supply

Consumer and Producer Surpluses

QS QD

Price

Quantity

Price Floor

Surplus Price Floor


The producer surplus is the extra revenue received by a firm which would be willing

to supply a good at a price below its current market price While all firms sell a good at the price determined by the market, presumably some

would be willing to supply the same amount at a lower price The extra revenue gained by these firms is the producer surplus The producer surplus is calculated in the same manner as the consumer surplus

The producer surplus area, however, is below the market price The producer surplus in the graph above would be the area of triangle B

The Consumption Decisions of the Individual Indifference curves

Individual consumption decisions based upon market prices depend upon the utility values attached to goods

When making purchasing or consumption decisions, consumers face an array of choices among competing goods

For any two goods, an indifference curve graphically represents the different combinations of two goods that bring the consumer the same amount of satisfaction

The indifference curve allows consumers to determine what combinations of goods will make them most satisfied (within budgetary limits)

The total utility value of an indifference curve depends on how far away the curve is from the origin

If the indifference curve is relatively close to the origin, the utility (or satisfaction) for every point on the indifference curve is relatively low

If an indifference curve is relatively far away from the origin, the utility for every point on the curve is relatively high

If a curve shifts away from the origin, the utility of all possible combinations of the two goods under consideration increases

Indifference curves generally slope downward As a consumer loses some amount of one commodity, he or she must receive more

of the other to be equally satisfied A consumer should always prefer a bundle, or mixed basket, of goods with more of

both commodities than one which features only one commodity Basically, consumers like variety

Indifference curves bend in toward the origin As one good is increasingly removed from the basket combination of goods,

increasing amounts of the other must be added to maintain the same utility value As the individual accumulates more and more of one good, he will require ever

larger amounts of the other good to make up for having less of the first good For example, as you take away more CDs from me, you’ll have to compensate

me with ever larger numbers of books The graph below shows Ian’s indifference curves for hamburgers and hotdogs

Every point on curve A yields Ian the same amount of total utility (satisfaction) The same relationship holds true for the other curve

Any point on curve B yields more satisfaction than any point on curve A Each combination on curve B has a greater overall number of hamburgers and

hotdogs than the combinations of curve A Since more goods are involved with curve B, Ian is more satisfied


Ian’s Indifference Curves

The willingness to give up one good for another is represented by the marginal rate of

substitution For example, let’s assume that Bookworm Bill is good friends with Audiophile Aaron

One day, Aaron decides he wants to trade some of his extra books for a few of Bill’s CDs

The two decide on a fair trade Bill will trade four of his CDs for two of Aaron’s books

Afterward, Bill’s satisfaction (total utility) is the same as it was before the trade Bill’s marginal rate of substitution is two books for four CDs, or one book

for every two CDs For Bill, one book and two CDs bring him the same amount of utility

The marginal rate of substitution defines the individual points along the indifference curve: it determines which baskets of goods maintain the same utility

Note that the marginal rate of substitution increases as the basket of goods becomes weighted toward a single good

This phenomenon is another manifestation of the law of diminishing marginal utility, which explains the shape of the indifference curve

If one examines two or more indifference curves on the same plane, these curves can never intersect

If the curves intersect at some point, then all of the points on both curves must have the same utility value as that point

This is because all points on an indifference curve are different combinations of two goods that yield the same utility value

Since a curve represents combinations of goods with the same utility value, it is simply not possible for two different indifference curves to share any point and still be separate curves

Indifference curves reveal only what consumers want or would be willing to consume To determine what consumers can actually consume, their incomes must be taken

into account The different combinations of two goods that a consumer can purchase given his or

her income is represented by the budget line The budget line is calculated by noting how many of each good the consumer

can afford alone and then connecting these two points

Hamburgers

Hotdogs

B

A


The result is a downward-sloping line which reveals the different combinations of the two goods the consumer can purchase

Consumers will seek to maximize utility per dollar by purchasing the combination of goods at the point where the budget line is tangent to the indifference curve50

Any alternative combination is above the budget line (unaffordable) or on a lower indifference curve and thus have less utility

Indifference Curve and Budget Line

Indifference curves have extreme variants for certain types of goods

For perfect substitutes, the indifference curve will simply be a straight downward-sloping line

In other words, the variety effect doesn’t matter For perfect complements, the indifference curve will have an “L” shape

Having ever greater quantities of peanut butter gives me no utility gains as I lose jelly

If a consumer actually despises one of the goods, his or her indifference curves will slope upward

A consumer gains utility by having less of a disliked good

The Production Decisions of the Firm Profit

Firms, or sellers, all produce with the goal of maximizing profits If a firm is consistently unprofitable, it will not be able to stay in business Profit is equal to total revenue minus total costs

Remember that total revenue equals total quantity sold times price per unit Profit is the excess gains remaining after the costs of land, labor, and capital have

been met Profit is technically the payment or reward for the entrepreneur, which allows him

or her to overcome the opportunity cost of other available production decisions In economics, there are a few different types of profits

Economic profit is any profit which is above the normal profit Economic profit can only be earned in the short run

50 For those of you who are math-challenged, “tangent” means “intersecting at one point and one point only.”

Budget line

Indifference curve Good A

Ideal point

Good B


In the long run, other firms will see the opportunity to make economic profits and enter the market

Firm entries will increase supply and thus decrease price, eventually erasing economic profits

Economic profits can only be maintained if barriers to entry exist to prevent new firms from entering the market

Normal profits are equal to zero economic profit In other words, the firm has met is economic costs exactly Keep in mind that a firm making normal profit is still making accounting profit

(see below) In the long run, firms must make a normal profit to remain in business

If a firm is not making a normal profit, then it will stop its current activity and move on to something else

Accounting profit is equal to total revenue minus accounting (or explicit) costs Accounting profit is not used by economists because it does not take

opportunity (implicit) costs into consideration Profit and costs

To maximize profits, all rational firms will produce until marginal revenue equals marginal cost51

Marginal revenue (MR) is the increase in total revenue a firm receives by selling one more unit of output

Marginal cost (MC) is the increase in total cost a firm must pay to produce one more unit of output

Marginal cost itself depends upon two other costs Fixed costs are costs a firm must pay regardless of how many units it produces

The more a firm produces, the lower its average fixed cost becomes for each additional unit

The cost is spread over more and more units of output By definition, fixed costs cannot be changed in the short run

A lease on a factory is a fixed cost: it must be paid regardless of how many units are produced, even if no units at all are produced

In the long run, however, all costs (including fixed costs) are considered variable

Variable costs change with the amount produced A firm only incurs variable costs when it produces something Examples of variable costs include wages (workers can be hired and fired),

and purchases of raw materials Producing more units of a good requires more laborers and more raw

materials If no units at all are produced, then a firm will not incur any variable costs

but will still have fixed costs Variable costs, by definition, can be altered in the short run

Average cost is the total production cost of each unit of output Average cost is calculated by adding fixed costs to total variable costs, and then

dividing by the total number of units produced

51 This sentence is often called the Golden Rule of economics. Do something until marginal revenue equals marginal cost (MR = MC) is the maximization strategy for nearly every economic activity you can think of (in some form or another).


(Total Fixed Costs Total Variable Costs)Average Total Cost

Total Number of Units Produced+

=

Fixed costs can be spread out over output The more a firm produces, the lower the average fixed cost (fixed cost per unit

of output) Variable costs increase as more variable inputs (such as labor) are added to fixed

inputs (such as capital) Variable costs drag average cost upward after a certain point of production

This upward trend is due to the law of diminishing returns As more and more variable inputs are added to the production process,

they become less productive Adding more workers in a factory, for example, doesn’t help boost

production if there are no machines for them to work with In the long run, all factors are variable, so all costs are variable

What would be considered a fixed cost in the short run is considered a variable cost in the long run

For all short-run decisions, firms face a mix of fixed costs and variable costs The marginal cost curve is usually U-shaped and resembles a rounded checkmark

As a firm produces more of a good initially, the marginal cost drops because the fixed costs of production are spread out over more units produced

After a certain point, the marginal cost curve climbs upward as variable costs increase

A firm must hire more labor, purchase more resources, etc., to increase production

The graph below features all the different types of costs just discussed Note the U shape of the marginal cost (MC) curve

Costs decline at first, then begin to rise after a certain point Also notice how the average fixed cost (AFC) curve continues to decline

This shape reflects the fact that average fixed costs continue to decline as more and more units are produced

Since average total cost (ATC) is equal to average variable cost (AVC) plus AFC, the distance between the ATC and AVC curves is the AFC

This distance decreases as the firm produces more and more units and AFC decreases

It is important to observe that the MC curve intersects the ATC and AVC curves at the minimum of each

This relationship between these curves is a result of the law of averages and marginals

The law of averages states that a marginal increase over the average will increase the average

Conversely, a marginal increase below the average will decrease the average

Sam’s class grade is the average, and his prospective score on the final is the marginal increase

To illustrate this law, let’s use an example Studious Sam is nearing the end of his AP Economics class, and he’s diligently

studying for his final Like many other students, he wants to know the grade he needs to get

on his final in order to get an A in the class


He knows that his average in the class is currently 90% Through his calculations, he realizes that any score on the final above

90% will raise his overall average grade Any score below 90% will lower his overall average

When looking at the graph, we can see the law of averages in action At all points to the left of the intersection of the MC and AVC curves, MC is

less than AVC As a result, AVC decreases until the two intersect

After the two intersect, MC remains above AVC As a result, AVC continues to rise

The same observations hold true when comparing MC and ATC

Cost Curves

Profit maximization

To graphically determine any given firm’s profit-maximizing level of output, plot the marginal cost and marginal revenue curves and note where they intersect

At this point of intersection, the additional cost of the next unit produced will equal the revenue it will bring in (its price)

If a firm produces below this point, it is under-utilizing resources and, consequently, not making as much profit as it could if it produced more

If a firm produces above this point, it is incurring more costs than revenue and, thus, losing money

Shutting down Let’s assume that Entrepreneur Eddie opens a bagel store

He has a few fixed costs He rents two bagel ovens for $1000 per month each His lease on the building costs him $3000 per month Each month, therefore, Eddie has $5000 in fixed costs

He also has a few variable costs He spends $500 each month on dough He also spends $300 each month on various bagel accessories, including cream

cheese, lox, and regular cheese His monthly electric bill comes out to $200

Electricity is a variable cost because it is related to how long Eddie stays open, how many bagels he bakes, etc.

Average fixed cost

Average variable cost

AFC

Marginal cost

Average total cost

Costs ($)

Quantity Produced


Each month, Eddie has $1000 in variable costs (at his current level of bagel production)

His total monthly accounting costs amount to $6000 Let’s also assume that Eddie’s next-best job would be working at Drew’s Donuts,

where he would be paid $500 per month Eddie’s opportunity cost, therefore, is $500 per month

Since total economic costs equal opportunity (implicit) cost plus accounting (explicit) cost, his total economic costs equal $6500 per month ($6000 + $500 = $6500)

If Eddie makes $7500 in one month, he’s earned $1000 in economic profit ($7500 – $6500 = $1000)

If he takes in $6500 of revenue in one month, he’s earned normal profits ($0) Earning normal profits is also called “breaking even”

The level of production at which this occurs is called the break-even point If Eddie makes $4500 in one month, he’s actually lost $2000

However, Eddie should not close his bagel shop Though he can’t cover all of his costs, he’s covered all of his variable costs

($1000) and $3000 of his fixed costs (plus his $500 opportunity cost) If he were to shut down, he wouldn’t have any variable costs, but he would still

have to pay all of his fixed costs ($5000) without making any revenue at all52 If Eddie makes less than $1000 in one month, he should close his store

At this point, he can’t even pay his variable costs If he remains open, he’ll have to pay both fixed and variable costs If he closes, he won’t have to pay his variable costs ($1000) He can put whatever he has toward his fixed costs, which he has to pay no

matter what For Eddie, $1000 in monthly revenue is the shut-down point

If he makes anything below $1000 in revenue, he should shut down his store In other words, the shut-down point is equal to the minimum of a firm’s average

variable costs53 Price discrimination

Price discrimination occurs when a firm charges different prices to different consumers for the same good

Essentially, a firm that price discriminates works to capture as much of the consumer surplus as possible and convert it into profit

“Perfect” price discrimination occurs when every consumer pays a different price The price that each consumer pays is the maximum amount he or she would be

willing to pay Consequently, no consumer surplus remains

The discrimination margin is the difference between different prices For price discrimination to be successful, a firm must be able to meet two requirements

First, it must separate the market into two or more groups based on their demand elasticity

Second, it must prevent the resale of its products In other words, those who are buying the good for less than others must not be

able to resell the good to those who would otherwise pay more

52 We’re talking about the short-run here. If Eddie closes down, he still has to pay his lease (and other fixed costs) at the end of the month. 53 In our example, we assume his level of production corresponds to the minimum of average variable costs for the sake of simplicity.


For example, let’s assume that Farsighted Farah is planning to go on a vacation to San

Francisco on April 10 She books her flight a month in advance with Generic Airlines and pays $150 for her

round-trip ticket On April 7, Businessman Brandon’s boss tells him that he needs to go to San

Francisco on April 10 to meet with some clients Brandon also books his round-trip ticket with Generic Airlines His round-trip ticket costs $225

This scenario is an example of price discrimination Brandon and Farah are purchasing the exact same good, but Brandon is paying

more Brandon’s demand for the flight is relatively inelastic

He has to go on a specific day, and there aren’t many days left before the flight by the time he’s bought his seat

Farah’s demand, on the other hand, is relatively elastic She has plenty of time to choose the airline she wants Her schedule is, presumably, somewhat flexible

Because of their differing demand elasticity, Brandon is willing to pay more for a ticket while Farah is willing to pay less

The airline successfully price discriminates by charging these two customers different amounts, thereby attempting to capture each consumer’s surplus

Price discrimination is legal and happens every day Senior citizens and students, for example, pay less for movie tickets because their

demand is more elastic As in our example, airlines charge different fares depending on how far in advance

the customer books the flight The Robinson-Patnam Act (1956) made certain forms of price discrimination illegal

It defined “harmful discrimination” as discrimination that leads to unfair competition Practicing price discrimination based on a consumer’s race, for example, is

considered “harmful” and, therefore, illegal

Market Structures Introduction

Consumers and firms/producers interact and exchange goods within markets Markets are created whenever potential buyers and potential sellers of a good come

into contact with one another to exchange goods or services The most effective method of exchange is money Alternative methods of exchange exist, such as barter (direct exchange of goods)

Exchange agreements (price and quantity exchanged) are determined through supply and demand

In microeconomics, a market is only concerned with one particular good Thus, economists refer to markets as a collection of homogenous transactions

General terms All markets for goods have a particular structure

The most important aspect of market structure is the number of buyers and sellers of the good in question

Markets are structured by the kind of competition between sellers in the market and whether any barriers to entry exist

Competition takes two general forms


Price competition is when firms compete based on price alone

Products are only differentiated by price, so sellers attract more buyers simply by lowering their price

Non-price competition is when firms compete in ways other than price The strategies of non-price competition aim to attract customers through

advertising or differentiation Advertising seeks to create a unique brand for which consumers are willing

to pay more Differentiation aims to convince consumers that one firm’s version of a

product is different from and better than other firms’ versions of the same product

Non-price competition can also be imposed by law If the government or a group of sellers sets a market price for a good, the

only way for firms to compete is through non-price competition Note that price still plays an important role in non-price competition

Barriers to entry are economic or technical factors which either prevent or make it prohibitively expensive for new firms to enter a market

Technical barriers to entry are obstacles which prevent a firm from entering a market

Patents are one example of a technical barrier See the section on laws and social norms (p. 60) for a more detailed

discussion of patents If the production of a good requires ownership or possession of a unique

resource, other firms will be unable to enter that market until they can acquire the necessary resource

The presence of well-known, existing brands in a market also presents a barrier to entry

New entrants will have to spend a lot on advertising to make their product known, making entry into the market expensive and extremely difficult

Legislation can also create barriers to entry Governments may enact licensing requirements or only allow a specific

number of firms to participate as sellers in a given market Economic barriers to entry are based upon economic theory and how firms produce

goods The production of some goods is only efficient when they are produced in large

numbers This condition is called economies of scale It is difficult for other firms to enter because the high level of production

requires an extremely high capital investment The production process for cars, for example, is only efficient at high levels

of output Alternatively, one can define economies of scale as when the total average cost

curve is downward sloping A downward sloping average cost curve means that the production process

becomes more efficient as the company produces more and more units An example is auto manufacturing

Since a car company has to build a large factory and hire thousands of laborers to work the assembly line, it is only profitable to make cars if the company can produce and sell a large number of them


Consequently, new firms have a tough time entering the market because the preexisting companies are already producing at high volumes

If, on the other hand, the total average curve is upward sloping, the production of the good is efficient at low output but inefficient at high output

This condition is called diseconomies of scale Diseconomies of scale is NOT a barrier to entry

Collusion among existing sellers in the market also represents a barrier to entry Existing firms can work together (collude) to set prices to prevent new firms

from entering the market Firms can also work together with firms in related industries to prevent new

firms from entering the market The combination of competition and barriers to entry determines the degree and type

of competition in a given market The illustration below shows the different market structures along a continuum of

competitiveness

Market Structures

Monopoly

Monopolies are markets54 in which only one large seller operates Monopolies have three general characteristics

Monopoly companies are motivated by profit They are profit-maximizers55

Monopolies either create or benefit from barriers to entry which prevent other firms from entering the market

Monopolies can determine the market price for their product The monopolist will sell at the profit-maximizing level of both output and price

Non-monopolies can only sell at the profit-maximizing level of output Monopolies are price-setters

As the only supplier, they can control the market price for their good by restricting or expanding supply

Monopolies can arise for purely economic (natural) reasons or artificial reasons Natural monopolies emerge when economic conditions make it practical for only

one seller to operate in a given market Natural monopolies emerge primarily through economies of scale If a natural monopoly exists, it is economically preferable for only one firm to

operate In this case, the government will usually work to regulate the natural

monopolist to ensure public welfare Examples include the Amtrak trains and (on a more local level) utility

companies (electricity, gas, water, etc.) Artificial monopolies result from purely artificial barriers to entry

54 And companies. And a board game. – Zac 55 No, this is not a real word, but don’t worry about it. – Zac

Less competitive Less efficient

Monopolistic Competition Perfect Competition Monopoly Oligopoly

More competitive More efficient


Examples include patents, copyrights, and similar property protections, all of which allow a firm to operate exclusively in a given market for a period of time

Government licensing or similar regulations can create artificial monopolies if only one firm is authorized to provide a good in a given geographical region

Natural monopolies result from market forces or the nature of producing certain goods Artificial monopolies result from the decisions or choices of persons, firms, and/or

governments Monopoly power is largely measured by whether the demand for the good a firm

produces is elastic or inelastic Monopoly power is the degree to which a firm can charge a higher price for its good

than would prevail if competitors were present The more inelastic demand is, the more monopoly power a monopolist has

Monopolies are generally viewed in a negative light and can impose costs upon society as a whole

Monopolies can purposefully engineer scarcity, or produce contrived scarcity In contrived scarcity, the monopolist produces less than what consumers

demand at the given market price Contrived scarcity drives up profits while at the same time leaving some

consumer demand unmet (thus decreasing the general welfare) In other words, monopolies produce less and charge more than is socially

optimal Monopolies impose a welfare loss on society, primarily through contrived scarcity56

By producing less and charging more, monopolies are able to capture some of the consumer surplus as producer surplus

Even more of the consumer surplus vanishes, with no one in society benefiting This lost surplus is called a deadweight loss

It is surplus lost by consumers but not regained by producers Monopolies can also be inefficient due to a lack of competition

While monopolies are profit-maximizers, they can still produce inefficiently due to laziness, incompetence, or just the lack of having someone else around to “keep them on their toes”

In competitive markets, inefficient firms are run out of business by more efficient firms

Monopolies can remain inefficient, which results in wasted resources, higher production costs, and higher prices for consumers

One can distinguish between monopolies which have “earned” their position, and those which have not

Microsoft is a monopoly which some have argued has earned its position It has provided products that consumers demand and maintained a measured

level of innovation Microsoft has earned its monopoly position in PC operating systems

Economic profits can act as a reward for such successes In looking at such “good” monopolies, many have argued that society can benefit

from the long-term innovation which may result from the reward of continued economic profit if a firm maintains its monopoly position

The flip-side of a monopoly is a monopsony: a market with only one buyer The buyer (rather than the seller) has control over the market

A bilateral monopoly is a market with only one buyer and one seller

56 “Contrived scarcity” is economics-talk for “purposefully undersupplying the market.” – Joseph


An example is the government’s exclusive contract with Halliburton to rebuild Iraq57 Hardly any true monopolies exist in reality

Competition is almost always present in some way, in the forms of alternative goods or otherwise

Perfect competition58 Perfect competition features many small sellers producing a single good In a perfectly competitive market, it is assumed that the goods produced by all firms are

identical, or homogenous In other words, there is no product differentiation

Perfect competition generally features three elements There are many firms, none of which has any power over market prices

The marginal revenue for each individual seller will thus be equal to the per-unit market price

The revenue brought in by selling one more unit is equal to how much it sells for on the market (its market price)

All firms aim to maximize profit They will produce at a point where MR = MC

There are no barriers to entry (or exit), allowing firms to move in and out of the market with practically no cost

Perfectly competitive firms are price-takers Since all goods are homogenous, firms cannot engage in product differentiation

They must accept the market price because they have no market power Normal profits are necessary for a perfectly competitive firm, but economic profits are

impossible except in the short run All firms must make normal profits to remain in the market

If a firm does not make at least normal profits, it is not overcoming the opportunity costs of staying in the market and will thus leave for better opportunities

Economic profits can be achieved in a perfectly competitive market, but only in the short run

Changes in the market might allow firms to charge a higher price for a short period of time

In the long run, other firms will notice the economic profits and enter the market, since there are no barriers to entry

The entry of new firms to the market will increase supply, which in turn will drive down price

The result is that economic profits are eliminated in the long run The demand curve for a perfectly competitive market is perfectly elastic

Consumers are very price responsive Any change in the price charged by a single seller will result in that seller losing all of

its customers Since goods exchanged are homogenous, consumers will have no preference for

one good over another, so they will simply buy the cheapest one In a perfectly competitive market, firms must obey the market price If the market price is below the point where MR = MC, firms will leave the market,

decreasing the supply and driving prices up until MR = MC again

57 My teammate, Atish, gave a speech about Halliburton at the speech showcase at the 2006 national competition in San Antonio, Texas. It involved Halliburton’s new exclusive contract to reconstruct Atlantis. Enough said. – Dean 58 Sometimes known as “pure competition.”


If the market price is above the point where MR = MC, economic profits will result,

leading more firms to enter the market and drive down supply until MR = MC again Because demand is perfectly elastic, it is equal to MR

Firms will only sell their good at one price, so every unit purchased (regardless of total quantity) brings in the same revenue

Further, MR and demand are both equal to the price of the good Perfectly competitive markets include most primary commodity markets

A classic example is the market for wheat All wheat is essentially the same, so all prices for wheat are the same

Another is the market for milk Perfectly competitive firms are unable to practice price discrimination

Any attempt by one firm to do so will just cause consumers to switch to another (nearly identical) firm

Perfect Competition (Market) Perfect Competition (Firm)

Monopolistic competition

Monopolistic competition is an intermediate stage between perfect competition and monopoly

Many competing sellers exist in the market, so firms do not have absolute market power

There are fewer sellers than in perfect competition, however Some barriers to entry exist, giving monopolistic firms some control over price (some

market power) Product differentiation exists

Products satisfy the same basic wants, but they are not identical as in perfectly competitive markets

Firms in a monopolistically competitive market still produce at a point where MR = MC since they are profit-maximizers

In a monopolistically competitive market, a firm can charge a price above the market price

Product differentiation means that firms engage in non-price competition Advertising, branding, and other activities allow a firm to make its product stand

out from alternatives Doing so allows a firm to charge consumers a high price for its differentiated

product

MC

Demand = MR = Price

Demand

Price

Quantity

Price

Quantity

Supply


Essentially, monopolistic firms use advertising and marketing to gain market power so they can imitate monopolist pricing techniques59

Advertising does not make sense in a perfectly competitive market because all goods are the same

Advertising is also not necessary for the monopolist because there are no other sellers

Advertising may play other roles, however, such as boosting demand for the product among consumers who may otherwise not demand it

Differentiated products present a barrier to entry for new firms because they must be able to successfully differentiate their product before they can compete

Product differentiation is an extremely expensive process that requires large investments in advertising

Due to barriers to entry and product differentiation, monopolistic competition allows sellers to become price-makers

They have some (though not complete) control over price The fashion industry is a great example of monopolistic competition

Brands spend huge sums of money on advertising to differentiate their products from the rest

Oligopoly Oligopolies are markets with a small number of interdependent sellers Firms in an oligopoly generally feature either highly differentiated products or

homogenous products In either case, oligopolies are characterized by long periods of price stability

In other words, there is almost no price competition, only non-price competition

The car market, for example, is an oligopoly of highly differentiated products The market for steel is an oligopoly of homogenous products The most notable oligopoly is OPEC

OPEC (Organization of Petroleum Exporting Countries) is an oil cartel that manipulates crude oil prices

American automakers also form an oligopoly Collusion is a common characteristic of many oligopolies

Collusion occurs when firms cooperate to artificially raise market prices by restricting supply

A group of firms that colludes to control prices is called a cartel A cartel essentially acts as a monopoly because all the firms work together

The main problem with collusion is the high incentive to “cheat” Since the market price is artificially high and the quantity supplied is artificially

low, a firm could make a lot of profit by supplying more than the other firms Doing so, however, would drive up the market supply and, in turn, decrease the

market price The other firms in the oligopoly would have to follow suit and lower their

prices, resulting in price competition Thus, the collusive agreement effectively self-destructs This situation is an example of the Prisoner’s Dilemma60

59 This is where the name “monopolistic” (“like a monopoly or monopolist”) comes from: monopolistic firms try to attain a monopoly over a very small segment of the market. 60 This topic, while extremely fascinating, is beyond the scope of USAD Economics, so it will not be covered here. It’s actually mentioned very briefly in the film A Beautiful Mind (it was originally theorized by John Nash).


All firms benefit from cooperating, but each faces a strong motivation to

cheat Despite the incentive to cheat, some firms do collude successfully (outside the U.S.)

Collusion was made illegal in the United States in the Sherman Act of 1890 (more on this act in macroeconomics)

There are three types of collusion: open, covert, and tacit When firms collude openly, everyone knows about it

The collusion is not a secret Covert collusion is done in secret, often to avoid anti-trust laws Tacit collusion is implied but never openly declared

In the bank industry, for example, certain firms often act as “leaders” Other firms “follow” changes in leaders’ interest rates

Tacit collusion is extremely difficult to prove There are three types of oligopolies

The first is the non-collusive, unorganized oligopoly This is the most common type Firms in the oligopoly are not cooperating They engage mostly in non-price competition They face a “kinked” demand curve (discussed below)

The second is the collusive, organized oligopoly This type of oligopoly is illegal in the U.S. Firms cooperate to raise market prices by restricting supply Since the firms all act together, this type of oligopoly is essentially considered

and studied as a monopoly OPEC is the most prominent example of this type of oligopoly

The third is the collusive, unorganized oligopoly Since collusion is illegal in the U.S., firms occasionally collude tacitly They are not organized into a cartel, but some unspoken rule governs certain

market decisions Oligopolies emerge primarily due to high barriers to entry

Differentiation of products provides one barrier, but the weakest Most oligopolies result from natural barriers to entry

The primary natural barrier is economies of scale Examples of oligopolies due to economies of scale include the automobile

and steel markets It is worth noting that globalization and the expansion of free trade work to

undercut most oligopolies (and monopolies) by creating larger, global markets that which can sustain a larger number of firms

Other oligopolies can result from artificial barriers to entry Patents and licenses can create oligopolies in the same ways that they create

monopolies, except a few firms are given patent protection or licenses instead of just one

Trade protectionism can also create oligopolies It prevents foreign firms from entering the market and keeps the relevant

product market artificially small


Non-collusive, unorganized oligopolies face a “kinked” demand curve (see graph

above)61 This demand curve was postulated by Paul Sweezy Let’s assume that the established market price for a given oligopoly market is $5 per

unit (represented by point A above) If Firm 1 decides to raise its price to $7, most consumers will just buy from

other firms These other firms will keep their prices at $5

They won’t follow Firm 1’s price increase Firm 1’s total revenue will probably decrease The demand curve for prices above the established market price, therefore,

is elastic If Firm 2 decides to lower its price to $3, most consumers will probably switch

to Firm 2’s product In order to reclaim lost market share, other firms will also lower their prices

to $3, perhaps even lower These firms, in other words, will follow Firm 2’s price decrease Since all firms’ prices have decreased, every firm will probably experience a

decrease in total revenue The demand curve for prices below the market price, therefore, is inelastic

Since firms lose revenue if they raise or lower their prices, the market price will usually hover at point A ($5 in our example)

The intersection of the elastic demand curve (for prices above the market price) and the inelastic demand curve (for prices below the market price) creates a “kink,” or bend, in the overall demand curve

Market price will usually stay at the kink (point A) Due to the threats of a price war and the incentive to maintain profits, oligopolies

generally work together (outside the U.S.) Firms in an oligopoly benefit from working together, making them interdependent Each firm relies upon every other firm to maintain the same prices But given incentives to “cheat,” oligopolies become very unstable Oligopolies become more stable when members have a way to sanction cheaters –

to impose costs or punishments Oligopolies, like all other firms, will seek to produce at a point where MR = MC

Price

Output

61 See that shape? Yup. That’s a kink. What’s a kink? That is a kink. – Lawrence

The Kinked Demand Curve

A


Institutions and Markets Overview

Markets rely upon institutions to ensure that they function properly The category of “institutions” in economics is broadly construed

Institutions can include government institutions, private institutions, laws, regulations, and even general codes of conduct or social norms

Institutions set the “rules of the game” They ensure the smooth functioning of markets by facilitating exchange

Financial institutions Financial institutions indirectly link savers with borrowers

Without financial institutions, borrowers would have to actively seek individual creditors, and creditors would have to individually seek borrowers

The result would be gross inefficiency Financial institutions provide information to creditors/savers about potential

investment opportunities, saving creditors from having to do their own research Financial institutions also reduce risks for creditors or lenders by spreading their

funds among many potential borrowers Depository institutions are a type of financial institution which receive money from

savers These savers indirectly lend their money to borrowers through the depository

institution Depository institutions attract savers through the payment of interest The most familiar example of a depository institution is the bank

Contractual savings institutions are a different kind of financial institution; they operate on a contract between savers and the owners/operators of the institution

Examples include pension funds and similar savings vehicles They differ from banks in that a contract is involved, especially when returns to

savings are guaranteed Another example not often associated with saving and lending is insurance

companies Insurance companies provide various financial and non-financial benefits such as

medical coverage and payments for damaged property Insurance companies take the money paid by savers (the buyers of insurance)

and invest it in various ways, providing funds to borrowers In 1933, the Federal Deposit Insurance Corporation (FDIC) was established to

restore confidence in financial institutions Each deposit at a financial institution that is a member of the FDIC is insured up to

$100,000 if the institution is unable to cover its assets Not all financial institutions are members of the FDIC62

Laws and social norms Less concrete institutions include the creation and enforcement of laws and norms The primary institutional “law” concerns property rights

Market economies are founded upon private property Property rights ensure the security of private goods

Owners of private goods can exclude other persons from using or otherwise enjoying ownership of their private goods

62 The FDIC is pretty important. Not more important than holding a towel, but close. Basically, the FDIC makes sure that if a bank collapses, not all its money is lost. – Lawrence


A car owner, for example, has the right to prevent other people from driving (or stealing) his or her car

Owners of private goods also have the right to dispense, rent out, or lease their own private property to others

This freedom applies not only to goods, but also to one’s labor power Public goods also exist63

Public goods are held by society (or the world) at large Public goods include publicly funded transportation systems (like highways),

public education, public parks, clean water, or even the global environment Persons cannot be excluded from using or enjoying public goods

In other words, public goods are non-excludable Public goods are also non-rival: one person’s consumption of a public good

does not reduce its availability to anyone else The fact that public goods are available to consumers at essentially no marginal

cost creates a rational incentive to overuse or abuse them The tragedy of the commons64 results from individual users exploiting or

overusing a common resource, thus degrading (or even destroying) that resource

Environmental situations, including excessive fishing and overgrazing of communal farmland, are the most common examples of this situation

Property rights ensure that individuals retain control over their property and can dispense with it as they see fit

Property rights generally cover possession of physical goods Property rights also extend to various forms of “intellectual property,” such as

artistic or scientific achievements65 These are made exclusive through copyrights and patents Patents created by law give firms or individuals the exclusive right to

produce a given good, preventing other firms from entering the market In exchange for this legal privilege, the legal entity holding the patent

must reveal every detail of the manufacturing process for the patented good

In the US, patents are usually effective for 17 years Copyrights apply to works of literature, art, or music in any medium

The holder of the copyright has the exclusive right to reproduce the copyrighted material or license it to others

Copyrights granted in 1978 or later last for the lifetime of the work’s creator and extend for 50 years after his or her death

Property rights as an institution require not only that such rights exist but that they are also enforced

Enforcement institutions are the most elaborate (and expensive) aspects of property rights

Enforcement institutions include police, the courts, and other legal institutions Property rights do not just protect one’s private property from others

The government can, in many cases, pose a great threat to private property

63 Public and private goods are discussed in more detail in the Macroeconomics section on free riders (p. 99). 64 This term dates back several hundred years to Britain. The “commons” were shared grazing land. The commons were exploited by farmers who let their livestock over-graze the land, thus destroying its usefulness for everyone. 65 Or a Power Guide… You have been warned. – Patrick


Though private property rights constrain the state in many ways, some exceptions allow the government to take control of property

These exceptions include eminent domain66 and compulsory purchase Property rights are the most basic of legal institutions, but there are others which are

also critical for the existence of a functioning market economy Enforceable contracts are required to facilitate transactions

For exchange to take place, individuals must be able to enter into contracts Contracts are especially important for exchanges that will occur in the future

or exchanges that occur over a long period of time If such contracts are to mean anything, a system of laws and courts must exist to

enforce and uphold private contracts The state also needs to abide by the rule of law

All economic agents know what the state can and can’t do because it is bound by existing laws

Knowing that the state cannot act arbitrarily gives individuals confidence Worrisome Walter would certainly be reluctant to buy a new car if he

thought the government might take it and use it as a new police car Part of this condition is the legal principal of due process

Due process encompasses many ideas, but its fundamental basis is that the government will not deprive any citizen of his or her legal rights

Laws must also be equitable In other words, laws must apply to all individuals and all situations equally Equality before the law assures individuals that the state will not act arbitrarily

and treat similar cases differently Equality also assures foreign nationals and firms that their actions in a country

will be judged by the same standards facing citizens and firms of that country Labor unions

Labor unions are collections of workers (often in the same or similar industries) which bargain collectively with employers to determine wages and working conditions

Craft or trade unions usually focus on specific crafts or jobs An example is the International Brotherhood of Electrical Workers

Industrial unions operate in more complex industries that require workers to perform many different tasks which often demand varying skill levels

An example is the United Auto Workers Many government jobs and offices are also unionized on both the local and national

levels in public employee unions Unions essentially act as labor cartels

Workers join forces (collude) to raise prices (wages) Labor unions, however, are exempt from most anti-collusion legislation

A significant early labor union was the Knights of Labor, which was established in 1869

Today, the AFL-CIO (American Federation of Labor and Congress of Industrial Organizations) is one of the most important unions

Union membership has declined since the 1960s In 1960, about 33% of American workers belonged to a union In 2003, less than 13% of American workers were members of a union

66 Eminent domain is the idea that the government can seize your house for public works use as long as they compensate you. This concept was important with the building of the freeway systems and, in general, almost all public infrastructure from sewers to subways. The practice was upheld by the Supreme Court in Kelo v. City of New London.


Unionization increases the bargaining power of individual workers through collective bargaining and restricting the labor force (creating an artificial shortage of labor)

Collective bargaining means that a union negotiates with employers on behalf of every union member

The Wagner Act (1935) guaranteed unions’ right to engage in collective bargaining

Successful unionization of a given industry or place of employment usually means that the union becomes the sole supplier of labor to a firm

In open shops, however, workers do not need to belong to a union They do not have to belong to a union to be hired, nor must they join a

union after they are hired Closed shops are places of employment where employers can only hire union

members These were outlawed in the 1947 Taft-Hartley Act

In union shops, employers can hire either union members or non-members Once hired, however, non-members must join the union The Taft-Hartley act allows states to pass right-to-work laws

These laws prohibit union shops Check-off provisions allow employers to deduct union fees from employees’

salaries automatically and pay the fees directly to the union The Taft-Hartley Act made these illegal, too

When a union is the sole supplier of labor, a firm must negotiate with the union in order to hire workers

In effect, the union is a monopoly, or the sole supplier of a good (in this case, labor)

By collectivizing, individual workers who are normally weak bargainers relative to employers join together into one force, strengthening bargaining power

If a union does not represent all workers or enforce certain rules, some individuals may accept lower pay or benefits than others

The availability of alternative choices (workers who will accept less) for employers reduces the power of unionized workers and the union as a whole

Unions can also exert leverage by organizing members in certain actions Picketing (organized demonstrations) can draw attention to labor problems,

discourage customers of the firm, and rally support for workers67 Strikes can shut down a firm as a union orders its members not to work

Strikes prevent a firm from operating, increasing the cost to the firm of not complying with union demands

Strikes, combined with picket lines, can have a “domino effect” Other unions may respect the strike and refuse to cross the picket line

Unions also exert pressure on employers by artificially restricting the pool of available labor, reducing supply and thus increasing price, or wages

This is most successful when unions include all of a firm’s workers Unions can also restrict the labor supply by limiting membership or by requiring

potential members to go through lengthy training programs before being allowed to become full members of the union

Unions negotiate with employers about several factors, including how much workers are paid, how many hours laborers work, how the employer handles grievances, and how the employer fires employees

67 This is the stage in which workers march around outside a firm carrying posters and shouting slogans. – Lawrence


A yellow-dog contract is a contract that an incoming worker signs in which he

pledges not to join a union The Norris-La Guardia Act (1932) outlawed yellow-dog contracts

In addition to wage bargaining, unions provide a number of services to members, as well as employers and society at large

Unions sometimes work to find members employment in the case of layoffs or job losses

Unions run pension and/or retirement programs for members, often bargaining with employers to fund such programs

Unions can train workers and ensure a higher quality of labor Unions also impose costs on society

By restricting the supply of labor, unions increase labor costs, which in turn increases the market price of final goods and services

By unnecessary apprenticeship and other programs, unions can restrict the freedom of individual workers to find employment under conditions of their own choosing

Unions can make the labor force less flexible As a result, the broader economy becomes less capable of coping with changes,

such as a move from labor-intensive industry to services Union membership in the United States has been declining steadily over the past twenty

years Unions were officially legalized by the National Labor Relations Act (1935) The Landrum-Griffith Act (1959) made union leaders more accountable in order to

help fight union corruption

Income Definitions

Income is the flow of money, goods, and/or services to any economic agent Potential economic agents include individual consumers, firms, and states

Income is more than just payments or cash receipts Economic income includes a variety of purely economic factors (in terms of

utility) A person who lives alone in a cabin in the woods derives no monetary income However, this person does derive a certain income in terms of “consuming” the

value of his land and the labor he spends to improve or maintain it Economic income is often classified by its sustainability over time

Permanent income is income which is sustainable for a long period of time When extracting natural resources, an entrepreneur can gain short-run income by

using or selling the resources immediately If the extractor takes short-run income and invests it, he or she can earn long-

run (“permanent”) income in terms of the receipts of such investments These gains can persist long after the original resource has been exhausted

General information The income of individual consumers is normally the return received from a factor of

production Individual consumers such as households sell factors of production (such as their labor)

to firms in factor markets Factor markets exist for each factor of production individually It is important to note that buyer and seller positions are reversed in factor markets

Households sell factors (inputs) while firms buy or consume them


Since firms demand factors of production in order to produce goods and services, demand for factors is referred to as derived demand

The demand for any given factor is dependent upon the demand for the good to be produced using that factor

For example, increased consumer demand for ice cream “derives” (leads to) higher demand for ice cream machines and ice cream factory workers

The total demand for any factor is the sum of the demand for that factor in each of its uses

The demand for rubber, for example, is the sum of the demand from the rubber band industry, tire industry, eraser industry, etc.

Supply and demand for factors of production are exactly the same as supply and demand for final goods and services

The only difference is that demand for corresponding final goods and services has an important effect on supply of and demand for factors

Wages and the productivity of labor When an individual sells his or her labor in the labor market, he or she earns wages

Wages are the return for human effort In the labor market, workers are the suppliers and firms are the demanders

The labor supply curve shifts if all workers decide they want to work more or less at a given wage rate

This type of change would require a massive change in social norms While wages can be quoted in hourly or salaried terms, the wage rate in economics

is the return to labor for every hour employed For example, Carlie the Camp Counselor makes $7.97 per hour68

Real wages are wages that are independent of inflation Real wages can be wages quoted in terms of the goods and services they can

purchase Real wages can also refer to wages indexed to inflation but still quoted in

monetary terms Both are essentially the same, but present the information in a different way

The former is in terms of goods The latter is in terms of prices at some given base year Either way, real wages are not affected by inflation

Nominal wages are the money received for work at the current price level An increase in one’s nominal wage does not necessarily mean that one’s real

wage has increased as well If the increase in nominal wage is actually less than inflation, then real wages

have actually decreased Real wages, in other words, represent the purchasing power of nominal wages

In economics, real wages are (ideally) determined by the productivity of labor For all factors of production, the price a firm is willing to pay for that factor is equal

to the marginal69 revenue product (MRP) of the factor MRP is calculated by multiplying marginal product by marginal revenue (price)

Marginal product is the extra physical output produced by employing one additional unit of a factor (such as one more worker)

68 This is actually the exact wage rate I earned when I worked as a junior counselor at a day camp near my house. Eventually, I realized that running around all day long with screaming kids in the hot summer sun for less than $8 an hour just wasn’t for me. Fancy that. – Dean 69 Recall that “marginal” means “one more” of something. Keep this definition in mind for this section.


Marginal revenue is the revenue gained by selling one additional unit of output (the price of that unit)

MRP of labor (or any other factor of production) is best illustrated with an example Let’s assume that Ted’s T-Shirt Factory produces plain white t-shirts70

Each shirt sells for $5 One day, Ted decides that he wants to increase his factory’s output He hires one more worker (Laborer Lawrence71) to see what happens

Lawrence’s marginal product is ten t-shirts The MRP of labor, therefore, is $50 (10 t-shirts x $5 per t-shirt)

Another day, Ted decides to buy another sewing machine for his workers The machine is a piece of capital, and its marginal product is 20 t-shirts The MRP of capital, therefore, is $100 (20 t-shirts x $5 per t-shirt)

MRP is dependent upon three factors The first is the productivity of the factor, or how much additional output can be

created by employing one additional unit of a factor More productive factors will result in a higher MRP and, ultimately, higher

returns The second is the current sale price of the good being produced The third is the rate at which the market price of the good will fall as additional

units are supplied Remember that a shift of the supply curve to the right (increased supply)

results in a decreased market price (ceteris paribus, of course) According to the marginal productivity theory of wages, a profit-maximizing

firm will hire workers until the wage rate72 equals the MRP of labor This rule is yet another manifestation of MR = MC

The marginal cost is the wage rate of each additional worker Firms will continue to hire workers so long as the MRP of each additional

worker exceeds the current wage rate Firms will stop hiring once the market wage rate and the MRP of the next unit of

labor (the next worker) are equal The employment of labor, like any other factor of production, is subject to

diminishing returns As more workers are employed at a given task, the marginal productivity of

labor will fall As more workers are added to a fixed stock of capital (the factories and

machines which are fixed in the short run), the productivity of those workers begins to fall

Consequently, the MRP of labor begins to decrease Additionally, hiring more and more laborers eventually leads to overcrowding in

the workplace73 Other, non-economic factors may influence firms’ decisions when hiring labor

Certain firms or managers may discriminate between workers based upon non-economic criteria such as race, sex, gender, religion, etc.

Such decisions are not profit-maximizing74

70 Buy they don’t produce the band, Plain White T’s. – Dean 71 Great name, if I may say so myself. – Lawrence 72 In this context, wage rate is synonymous with “marginal resource cost” (the “resource” being labor). A profit-maximizing firm will keep hiring workers until MRC = MRP. 73 Or, as my old econ teacher said, “You eventually get that guy who brings in the six-pack and the boom box.” – Dean 74 Nor are they legal in the US of A. – Zac


The rational firm will almost always take the MRP into account and employ the most productive workers irrespective of other factors

By discriminating based on non-economic factors, the discriminating firm suffers a loss in potential productivity

The MRP of labor (and, thus, wages) can be increased by increasing the productivity of labor

Investments in physical capital (factories, machines, etc.) can increase the productivity of labor and, subsequently, the MRP of labor

By making labor more productive, a firm will require fewer workers to produce the same (or greater) output

Consequently, a firm can pay its laborers higher wages The higher productivity of labor with improved physical capital is one reason

why manufacturing workers in the US or the EU are paid higher wages than workers in China

Tasks are less labor-intensive in a more developed economy, so firms in developed countries can hire fewer workers than firms in less-developed nations

Labor itself can be improved by investing in human capital Human capital consists of the skills and knowledge possessed by a unit of labor

or the labor force as a whole Investing in human capital makes labor more productive even without improving

surrounding physical capital These investments result in increases in the MRP of labor and in wages These higher wages are a type of a return on the investment of education

The primary means of improving human capital are education and job training To improve the performance of the economy as a whole, countries can invest in

mandatory primary and secondary education to improve the human capital of the entire population

Labor productivity can also be improved through technological progress As technology improves, labor (as well as capital) becomes more productive The development of new machines, robots, computers, etc. has contributed to

increasing labor productivity and higher wages Wages may also vary for seemingly random and inexplicable reasons

One primary example is how wages can vary in different regions in the same country even when workers are equally productive

If prices and labor productivity are the same in different places, wages should theoretically be equal

Often, price differences among areas are the reason for wage differences75 Different price levels result in different nominal wages

However, real wages across regions should remain the same as long as the real price of the final good and the productivity of labor are the same

Like all other factors, the demand for labor is derived demand Thus, it depends upon the demand for the final goods produced

Rent76 When individuals (or households) sell land, payments are received as rent

75 For instance, the cost of living in Southern California is much higher than that in rural Utah. That was not an advertisement for moving here. In fact, if you value your sanity, I suggest you stay far, far away. – Patrick 76 Rent in economics is a complex topic. We give several definitions here in hopes of achieving clarity and helping you recognize whatever USAD might throw at you on a test.


In economics, rent encapsulates all payments for land (natural resources) Rent includes money from selling extracted oil or felled trees to the payments

received for leasing land Economic rent is return to any input over and above its opportunity cost

Although this may seem totally different from our traditional conception of rent, it’s actually just a broader term that includes traditional rent

The opportunity cost of land is zero: there is no alternative So, rent for land is automatically a payment over and above its opportunity

cost Another definition of rent is the price of a perfectly inelastic resource

Saying a resource is perfectly inelastic is the same as saying it has an opportunity cost of zero: no alternative exists

Senior members of a firm (those who have worked there for a long time) are often paid more than others with the same job

The extra pay that these senior members receive is a form of economic rent Their opportunity cost is the salary they would receive as normal employees In other words, these senior members are willing to work for a certain salary

They are attracted to the job by that amount Because of their senior status, they are paid more than they demand This extra pay is economic rent

Yet another definition of rent is profit that a resource owner makes without producing anything77

A landlord who leases out an apartment complex makes profit, but he or she does not actually produce any new goods

Similarly, a senior member of a firm who gets a higher salary by virtue of his seniority has not done anything to “produce” his seniority

Interest The returns an economic agent receives from capital are referred to as interest Interest derives from investment in capital development

Investment is the creation of capital which will produce goods for future consumption

Investment demands that individuals sacrifice current consumption for future consumption

The only way individuals will be persuaded to sacrifice current consumption for future consumption is if future returns are greater than those passed up in the present

Interest is the extra payment that entices economic agents to invest In classical economics, interest is the rate of return on capital investment

With modifications to classical economics, interest is now seen in a broader light Interest is now determined by the interaction of supply and demand for funds The interest rate can also be viewed as the price of money (discussed in

macroeconomics) Profit

The returns to individuals from entrepreneurship are known as profit Profits are the residuals after returns to land, labor, and capital have been distributed Entrepreneurs take risks by combining or using the other factors of production in new

or unique ways to create new goods or to produce existing goods more efficiently Entrepreneurs are not always successful; there is always the risk of failure

77 Paraphrased from Economics: Principles and Policy by Baumol and Blinder (pgs. 403-406).


For entrepreneurs to take risks, a reward (incentive) must be offered in the form of

profits One way of reducing risks to entrepreneurial activity is through property rights

By granting property rights to the entrepreneur over new products or methods of production, an additional risk is eliminated

Property rights prevent others from copying the entrepreneur’s ideas (which are a form of intellectual property) and subsequently reducing his profits

Property right protections in this case are mostly in the form of intellectual property rights, such as patents

Income on a larger scale The income of firms equals total sales minus costs The income of states or countries is the sum of all incomes in the country or of all

citizens of that country (discussed in macroeconomics)


MACROECONOMICS POWER PREVIEW POWER NOTES

This section will focus on macroeconomics. Macroeconomics studies entire economic systems, which are the aggregate actions (or results of the aggregate decisions) of the individual agents studied in microeconomics.

30% of the exam (15 questions) will focus on macroeconomics



Macroeconomic Basics Overview

Macroeconomics is the study of the entire economy It focuses on the aggregate (or total) effects of the behavior of individual economic

agents Macroeconomic concepts can be analyzed independently of the behavior of

individual agents Macroeconomics generally distinguishes four sectors in the economy: businesses,

households, the state (government), and foreign entities Although it operates on the same principles as microeconomics, macroeconomics can

reach different conclusions Many decisions that are beneficial for individual economic agents would be harmful

to society if all economic agents simultaneously made the same choices However, basic principles (such as the laws of supply and demand) operate in

macroeconomics just as they do in microeconomics

Aggregate Demand and Supply Aggregate demand

Aggregate demand (AD) is the total demand of an economy at any given price level It is the sum of all expenditures in an economy

Aggregate demand has four components Consumer spending on goods Investment spending (usually by firms) on capital equipment and inventories Government spending on goods for the state or the public welfare Net exports, or the total value of goods exported minus the total value of goods

imported Adding these four components yields aggregate demand Adding these four components is also one method of calculating GDP (Gross

Domestic Product, which will be discussed later) Aggregate demand can be graphed

It looks similar to the demand curve for an individual market While the curves look the same (both are downward sloping), they represent

relationships between two different sets of variables The aggregate demand curve shows the relationship between the price level

(vertical axis) and the level of output (horizontal axis)


Price

Price level is an index of the average prices in the economy A higher price level means that all goods are, on average, more expensive

Level of output is the sum of all goods and services produced in an economy in real terms (adjusted for inflation)

Some textbooks refer to it as “Real GDP” instead (which is essentially the same thing)

Aggregate demand is downward-sloping for three reasons

The first is the wealth effect As the price level decreases, consumers’ real incomes increase, allowing

them to buy more goods Remember that real incomes are adjusted for the price level If the price level goes down but nominal wages stay constant, the real

value of the nominal wages increases This increase in purchasing power leads consumers to an increase in the level

of output demanded The second is the interest effect

As the price level increases, more money is needed for transactions As a result, more people try to borrow more money This competition is essentially an increase in the demand for money, so real

interest rates (the “price” of money) increase This increase makes borrowing more expensive, discouraging consumption

and (primarily) investment Consequently, aggregate value demanded decreases as price level increases

The third is the trade effect (or open economy effect) As the price level of domestic goods decreases, domestically-produced goods

become cheaper internationally The result is an increase in domestic consumption and exports which

increases the level of output demanded Like the market demand curve, the aggregate demand curve can shift

There are six changes that cause shifts First, the distribution of income can change

If households with a higher propensity to consume increase their share of total household income, aggregate demand will shift to the right (outward)

The propensity to consume is what percentage of after-tax income households spend on consuming goods

In this situation, consumption (one of the components of aggregate demand) increases

Level

The Aggregate Demand Curve

Level of Output


If households with a lower propensity to consume increase their share of total

household income, aggregate demand will shift to the left (inward) Generally, poorer households will spend a higher percentage of their income on

goods In comparison, wealthier households will save a higher portion of their

income In other words, they have a higher propensity to save

Propensity to save and consume will be discussed in more detail with fiscal policy on p. 114

Second, firms can change their investment spending To increase investment spending, a firm spends more on capital goods, which

will shift aggregate demand to the right In this situation, investment (one of the components of aggregate demand)

increases Firms increase planned investment spending because they expect to do well in

the future or see future opportunities for which they need to prepare If future expectations are poor (firms expect rough times ahead), firms will

decrease planned investment, which will shift aggregate demand to the left Third, the income of foreign entities may change

If the income of foreigners changes, exports will change Remember that net exports is one of the components of aggregate demand

If foreign nation B becomes more affluent, its citizens will spend more on goods exported from nation A

This change will shift the aggregate demand in nation A to the right If foreign nation B becomes poorer, its citizens will spend less on goods

exported from nation A This change will shift the aggregate demand in nation A to the left

Fourth, changes in foreign currency exchange rates can also impact aggregate demand

If the dollar depreciates against foreign currencies, imports become more expensive and American exports become cheaper for foreigners

This change leads to an increase in exports and a decrease in imports, which in turn shifts aggregate demand to the right

When a currency depreciates, it becomes less valuable relative to another If the dollar appreciates against foreign currencies, imports become less

expensive and American exports become more expensive for foreigners This change leads to a decrease in exports and an increase in imports, which

shifts aggregate demand to the left When a currency appreciates, it becomes more valuable relative to another

For additional information on exchange rates, see the section on International Trade and Development below

Fifth, changes in expectations concerning the price level can also shift aggregate demand

If consumers expect price levels to increase (inflation) in the future, they will buy more goods now, thus shifting aggregate demand to the right

If consumers expect price levels to decrease (deflation) in the future, they will wait to buy some goods, which will shift aggregate demand to the left

Sixth, the government can directly impact aggregate demand through its own spending


By increasing or decreasing government spending, the government directly changes one of the elements of aggregate demand, shifting the curve by itself

Government influence over aggregate demand is the foundation of Keynesian economics (see Fiscal Policy below)

Remember that a shift in the aggregate demand curve represents a change in the level of output demanded at all price levels

A change in the price level itself, however, only causes a movement along the aggregate demand curve

Aggregate supply Aggregate supply (AS) represents the potential supply of all goods at any given price

level Short-run aggregate supply

Short-run aggregate supply (SRAS) represents the potential supply of all goods at any given price level in the short-run (not in the long-run)78

Long-run aggregate supply is different and will be discussed in the next section Prior to Keynes, economists thought that aggregate supply determined national income

This theory is known as supply-side economics Supply-side economics attempts to increase overall welfare by boosting supply-

side factors, which, in turn, will increase the overall supply of goods An increase in aggregate supply leads to lower price levels and higher total

output Jean-Baptiste Say developed a theory called Say’s law79

Say’s law states80 that supply creates its own demand: demand will increase to match increased supply

In other words, a good is demanded simply because it is supplied Supply-side economics has many variations (both free-market and state-centered)

and was vigorously attacked by Keynes Keynes reversed the relationship, postulating that increasing aggregate demand will

signal firms to increase production, which will cause an increase aggregate supply Short-run aggregate supply can be graphed like market supply

The curve is upward-sloping A direct relationship exists between the level of output and the price level

As the price level increases, suppliers across the economy increase production Shifts in the short-run aggregate supply curve can occur for four reasons

First, improvements to or changes in the labor force can shift the curve If labor increases in quality or size, aggregate supply will shift to the right

(outward) If labor decreases in quality or size, aggregate supply will shift to the left (inward) Changes in work hours or work habits across the labor force can also influence

the aggregate supply curve Second, technological progress can shift the curve to the right

If technology improves, then the productivity of all factors of production will increase, which will increase total output at all price levels

Third, government taxes and subsidies can result in a shift

78 When economists (or USAD, for that matter) say “aggregate supply,” they are generally referring to short-run aggregate supply. 79 Say’s Law is testable. Remember it! – Zac 80 I fought long and hard to resist the urge to use the word “says” here instead. – Dean


If the state increases taxes on suppliers throughout the economy, then total output will decrease at all price levels, shifting the curve to the left

If the state provides subsidies or other transfers to firms throughout the economy, then total output will increase at all price levels, shifting the curve to the right

Fourth, expectations of inflation can cause a shift If firms expect inflation, the curve will shift to the left as firms try to save money

now to meet higher costs later Remember that changes in price level lead only to movements along the short-run

aggregate supply curve, not shifts in the curve itself The short-run aggregate supply curve splits into three regions when we factor in other

considerations (see graph below) The first region is called the Keynesian region

It is the leftmost portion of the curve At this segment of the curve, the economy is operating on very low production

levels In fact, the economy is probably experiencing a recession Unemployment is likely very high, and society probably isn’t using resources

very efficiently As a result, increasing output will not cause any inflation

Rather, production will simply become more efficient as unemployment drops and resources are utilized

Consequently, this region of the graph is horizontal Eventually, an economy in this region will regain its health and move back toward

higher levels of production When this change occurs, the economy moves out of the Keynesian region

and into the intermediate region The intermediate region is the link between the Keynesian and classical regions

(which will be discussed momentarily) When we discuss short-run aggregate supply, we are generally referring to the

intermediate region It resembles the regular supply curve: it is upward sloping (but not vertical) An economy in this region is normal and healthy

Increases in output lead to increases in price level (inflation) If an economy increases production drastically, it will eventually move out of the

intermediate region and into the classical region The classical region is the third and rightmost segment of the curve

Here, we encounter the production limits (or “capacity constraints”) of an economy

Production is already so high that firms are longer be able to increase output because all factors of production in the economy are being utilized

As a result, the curve is vertical, or perfectly inelastic As much as firms might want to respond to changes in the price level, they

are unable to do so At this level of output, the economy is actually employed above full

employment81 The economy can only maintain this “overheated” state temporarily, if at all

81 As will be discussed later, full employment is NOT 100% employment. It is actually closer to 96% employment.


Eventually, it will move back toward a lower level of production (and into the

intermediate region again)

Short-Run Aggregate Supply

Level of Output Capacity Constraints

Classical

Keynesian

Intermediate

Price Level

Long-run aggregate supply

Long-run aggregate supply (LRAS) behaves slightly differently The long-run aggregate supply curve is determined by the availability and

productivity of the factors of production In the long run, supply is independent of the price level As a result, the long-run aggregate supply curve as a whole is perfectly inelastic, or

vertical Changes in the aggregate supply curve can only come in shifts resulting from changes

in the productivity of the factors of production The output level of the long-run aggregate supply curve is at the point of full

employment If the LRAS curve passes through the intersection of the SRAS curve and the

aggregate demand curve, the economy is in “long-run equilibrium” (see graph below)

If the LRAS curve does not pass through this point, the economy is either experiencing inflation or recession

A recession is when the production level of long-run aggregate supply is greater than the current level of production

The economy’s production potential is not being realized According to classical economic theory, prices will fall, consumption and

production will increase, and the economy will move back to long-run equilibrium

Inflation occurs when the production level of long-run aggregate supply is less than the current level of production

Factors are being over-utilized and the economy is “overheated” According to classical economic theory, prices will rise, consumption and

production will drop, and the economy will move back to long-run equilibrium


An Economy in Long-Run Equilibrium

National Income Introduction

National income is the total income of all agents in an economy in a given period Measurements of national income effectively mirror aggregate demand

National income should include all consumption expenditures A variety of methods and means are used to measure and examine national income

The one on which we will focus is Gross Domestic Product or GDP GDP

GDP is the value of all final goods and services produced within an economy in a year GDP is typically calculated by summing total outputs of all goods at market prices GDP only includes the values of final goods and services

Final goods are goods which are consumed and not used to produce anything else Two examples are a new box of tissues and this Power Guide82,83

Intermediate goods are goods which are used to produce other goods Adding intermediate goods to GDP would result in double-counting The value of intermediate goods should be reflected in the final market value of

final goods The value of the engine of a new Ford Mustang is included in the price of the

car Only the car (and not the engine) would be counted in GDP

By definition, GDP includes only those goods produced within the borders of a given economy

Goods produced in the United States by foreign firms are factored into the United States’ GDP

Goods produced outside the United States by US-based firms are NOT factored into the GDP of the United States

82 Please remember that the two are not substitutes. – Dean 83 Nor are they complements. Unless, of course, you have a cold while you’re reading this. Or if economics just brings you to tears. – Lawrence

LRAS Price Level

SRAS

A

Level of Output

D

Full Employment Output

Capacity Constraints


Gross National Product (GNP) includes all final goods produced by United States nationals (individuals and firms) wherever they are in the world

It excludes all foreign individuals and firms (even if they are in the United States) For example, a McDonalds Big Mac sold in Tokyo is included in the United States’

GNP It is NOT included in the United States’ GDP It is, however, included in Japan’s GDP

Most economists prefer to use GDP rather than GNP GDP is measured at market value

Market value is the current price of a good Calculating GDP thus involves summing the prices of all final goods sold in the

United States within a year GDP measures the size of an economy and not necessarily its health or the welfare of

the people in that country For example, Indonesia has a GDP of $827.4 billion84 while Ireland has a GDP of

$126.4 billion Based upon this alone, one would expect Indonesia to be a much nicer place to

live than Ireland However, Indonesia also has over 60 times as many people as Ireland

The wealth of Indonesia is divided among many more people than the wealth of Ireland

Thus, to get a truer picture of national well-being, per capita GDP should be examined

Per capita GDP is equal to GDP divided by the population of the given region “Per capita” basically means “per person”

In the above example, Indonesia has a per capita GDP of approximately $3500 while Ireland’s is approximately $31,900

Some economists think that per capita GDP is itself a poor measure of national well-being

Per capita GDP ignores other factors (such as health, environmental factors, education, the distribution of income, and even happiness)

Alternative measures of national well-being have been developed, such as the United Nations’ Human Development Index (HDI)

This index is represented by a number between zero and one Nations with higher numbers have a higher level of well-being

Other economists point out that nearly all alternative measures are closely correlated with per capita GDP measurements

Alternative measurements also are difficult to accurately measure For example, how does one measure the happiness of a person?85

GDP figures are often calculated by various agencies within national governments In the United States, GDP is calculated by the Bureau of Economic Analysis, which is

part of the Department of Commerce The Bureau reports GDP figures quarterly (every three months)

As of 2006, the GDP of the United States was $13.13 trillion (the highest in the world) According to the CIA’s World Factbook, the per capita GDP of the United States was

$44,000 in 2006

84 All data is from 2004 at Purchasing Power Parity (PPP), unless otherwise noted. 85 A fine question. Bhutan, a small South Asian country, has been trying to answer it since 1972, when the nation started measuring its growth in Gross National Happiness (GNH) rather in than GDP. – Patrick


This per capita GDP was the ninth highest in the world

The US is below Luxembourg, Bermuda, Jersey, Equatorial Guinea, the United Arab Emirates, Norway, Guernsey, and Ireland (in order from first to eighth)

Measuring GDP GDP can be measured in several different ways The most frequently used approach for calculating GDP is the expenditures

approach Using expenditures approach, one sums all expenditures in an economy within a

year The expenditures approach breaks down expenditures into four categories

Consumption expenditures (C) include the values of all purchases of goods designed for consumption

These goods, by definition, must be final goods Additionally, used goods do not count

They were already counted when they were purchased as new Further, the purchase of stocks and bonds does not count in GDP because

no goods or services are involved These transactions are purely financial

Investment expenditures (I) include the values of all investment spending Interestingly enough, buying a home is considered investment, not

consumption Similarly, construction work is also considered investment

Government expenditures (G) include the values of all government purchases

Net exports (NX) include the values of all exports minus the values of all imports

Essentially, the expenditure approach is calculated in the same fashion as aggregate demand: GDP = C + I + G + NX

GDP is sometimes expressed as “Y” In the United States in 2003, consumption accounted for about 70% of GDP,

government spending 20%, investment 15%, and net exports -5% Government spending varies widely among economies

Economies with greater state intervention have far higher government shares of GDP

Even with the explosion of world trade in the past half-century, trade (net exports) still accounts for a relatively tiny portion of GDP

Investment spending is spending on either capital goods or inventories Capital goods are capital equipment, such as new machines, factories, or other

items (PCs, cash registers, etc.) In other words, capital goods are used to turn inputs into outputs

Inventories include goods which are produced but not consumed in the measured time period

For example, if Steve’s Steel Company produces 1000 tons of steel in 2003 but only sells 800 tons, the 200 tons left over are factored into GDP as investment spending

These 200 tons add to Steve’s inventories When inventories are later used up, they are SUBTRACTED from GDP in

the year they are used If the 200 tons of steel are then sold and used in 2004, the value of the

that steel in current prices is subtracted from the 2004 GDP


This subtraction ensures that inventories are not double-counted Investment spending can either be planned or unplanned

Planned investment spending is what firms intend to invest in a given year In other words, it’s how much they intend to spend on capital and how much

they intend to add to inventories Unplanned investment spending86 is investment spending which the firm

does not initially intend to make Unplanned investment spending nearly always takes the form of unexpected

inventories Let’s assume that Steve’s Steel Company produces 1000 tons of steel in 2003

and plans to sell 800 tons but only sells 700 Steve has planned investment equaling the value of the 200 tons of steel it

intended to add to inventories Steve also had unplanned investment equaling the value of the 100 tons of

steel which he was unable to sell Planned investment spending plus unplanned investment spending equals total

investment spending Government spending generally focuses on public goods

Examples of government spending include infrastructure (such as highways) and government services (public healthcare or law enforcement)

Governments can directly impact GDP by changing its own spending This practice is known as fiscal policy (see p. 112)

Governments also allocate significant amounts of money for transfer payments which are NOT factored into GDP

Transfer payments are payments not in exchange for goods or services They are made from the government to individuals Examples include unemployment insurance, Social Security, and welfare

payments Transfer payments do not produce or provide anything

They simply move money around and, thus, are not factored into GDP An alternative way of calculating GDP is the national income approach

Using the income approach, one adds together all payments for factors of production and then subtracts certain items to find national income

National income includes several components: Wages (and salaries) Profits of private firms Interest payments to those who have loaned money Rents87 to those who have rented or otherwise loaned certain goods or

resources Rent is the smallest component of the income approach

Also, indirect taxes (such as sales taxes) and subsidies (government price-supports for goods) are eliminated

Taxes are added back in, and subsidies are subtracted The income approach is also known as national income accounting When depreciation of capital is factored into the income approach, Net

Domestic Product (NDP) is the result From year to year, capital breaks down or wears out

86 This sounds like a euphemism. It’s not product that we failed to sell, it’s “unplanned investment spending.” – Patrick 87 Note that these first four components are essentially the same as the payments for the four factors of production.


This “wear and tear” is known as depreciation In other words, depreciation is the consumption of fixed capital

Depreciation takes value out of the economy Depreciated capital must be replaced

Subtracting depreciation of capital from GDP yields NDP Following is a summary of the various calculations associated with the national

income approach GDP – depreciation = NDP NDP – indirect business taxes = national income (NI) NI – Social Security tax + transfer payments – retained earnings = personal

income (PI88) Retained earnings include all the money that corporations make but do not

distribute as profit PI – income taxes = disposable income (DI)

Disposable income is the amount of money that consumers actually have available to spend

It is disposable income that determines consumers’ level of consumption A final method for calculating GDP is with the value-added approach

Using the value-added approach, one calculates GDP by adding the value-added to a good at each stage of its production

As a good is produced, it passes through multiple steps The value-added approach analyzes each step in the production process and then

factors in the value-added at each step to calculate total value Value-added is the price at which a good sells minus the cost of the goods (or

resources) used to make it Value-added presumably represents the value a firm or individual adds to a

given good in one step along the production process Real and nominal GDP89

Nominal GDP is GDP valued at current prices Nominal GDP is linked to, and heavily influenced by, the changing value of money If the value of money decreases (inflation), prices will increase

The result is an increase nominal GDP This increase only reflects an increase in prices, not an increase in total level

of output If prices increase enough, actual output can drop and nominal GDP remain the same

Real GDP is GDP adjusted to account for changes in prices Real GDP eliminates a problem associated with nominal GDP

Changes in the price level do not distort our perception of total output Nominal GDP can be adjusted to real terms in two ways

A base year can be chosen, and all prices converted to the prices in that base year

Indexing prices to a base year makes them constant A GDP deflator (or GDP price deflator) can also be calculated to measure

changes in the price level relative to changes in GDP from year to year A GDP deflator allows nominal GDP to be converted to real GDP based on

changes in the price level

88 Not pi the number, and not pie the baked good. PI as in personal income. – Lawrence 89 Nominal always means before adjusting for inflation, and real always means after doing so. USAD loves these terms. So know them. – Patrick


Both methods convert nominal prices into prices that are “constant”

Constant prices do not change with inflation They stay the same (remain constant) from year to year (starting from a base

year) Use the formula below to covert GDP figures with the GDP deflator

1 1

0 0

=Deflator GDPDeflator GDP

Limitations of GDP GDP, no matter how it is calculated, misses a substantial amount of activity GDP does not include activities which are not priced in markets

Examples include cleaning your house, cooking your own gourmet meal, or building your own computer from spare parts

While certain goods used in these activities are factored into GDP, the value-added by personal labor is not included

Not counting personal activities in GDP can misrepresent total economic output In developing economies, much of the labor force is involved in subsistence

agriculture – people produce for their own needs Even though subsistence agriculture results in usable output, it is not counted

because it is not sold in markets The result is a gross misrepresentation of economic activity

GDP also leaves out the resale of existing goods (used goods) Buying a used car is not factored into GDP because no new value was added to the

economy The sale of your rare, mint-condition Transformer figures still in the box on eBay is

also not counted in GDP as this is not a “new” good, even if the value of that Transformer did appreciate substantially90

For example, the Jetfire figure would have cost you about $15 in 1985, but will now set you back around $160, the last time I checked91

GDP also leaves out activities which take place outside formal, legal markets The illegal sale of goods, or simply the sale of illegal goods, is not factored into GDP

because these sales take place in black markets The sale of narcotics in the United States, for example, is not factored into GDP,

though one could (presumably) argue that this reflects value-added activity Additionally, activities outside of formal markets are left out simply because they are

outside of channels which can be monitored by the state For example, if Generous George pays his son, Diligent Dave, $15 for mowing

the lawn, it’s unlikely that Dave would report this to the government as income92 This payment, therefore, is not included in GDP

In some countries, large amounts of economic activity take place in black markets As a result, total economic activity in those countries is undercounted

The Gini coefficient and the Lorenz curve93 The Gini coefficient and Lorenz curve are used together to show the wealth

distribution of a given country The Gini coefficient can range anywhere from zero to one

90 Probably even more now that the movie has come out. – Dean 91 A point of clarification: Joe is the Transformer geek. Not me. Thanks. – Dean 92 Tax-evading hooligan. – Patrick 93 These topics will only be tested on a very basic level, if at all. The discussion of them in this guide, therefore, will be very brief and simple.


A Gini coefficient of one means that one individual has 100% of the total wealth

of that country A Gini coefficient of zero means that wealth is distributed entirely equally in that

country Every individual has the same amount of wealth

The Lorenz curve is the graphical representation of the Gini coefficient

The Circular Flow Model Overview

The circular flow model shows the relationships between different sectors of the economy

The circular flow model, at its most basic level, has two main components Households provide resources which are used to make goods (factors of

production) and purchase goods in the market Firms (also referred to as the business sector) consume resources to produce

goods and sell these to households in the market The circular flow model also has two basic markets, both of which are governed by the

forces of supply and demand The market in which firms buy factors of production from households is called the

factor market The market in which households buy final goods and services from firms is called the

product market The circular flow model illustrates how households and firms are mutually dependent

upon one another The household and business sectors essentially equal consumption and investment

spending, respectively, in aggregate demand Complicating the model

The addition of other actors in the circular flow model reflects the different components of GDP and aggregate demand

The government can be added to the circular flow model to include the impacts of government spending on economic activity

The government taxes firms and households to support government spending, creating a leakage

A leakage is when resources “leak” out of (exit) the circular flow model The government provides transfer payments or subsidies to households and firms,

creating an injection An injection is when resources are “injected” into (enter) the circular flow

model When leakages and injections balance each other out, the government plays little

role in the circular flow of resources When leakages and injections are unbalanced, government spending can influence

the circular flow If the government injects more money than it takes in, it can stimulate the

economy If the government collects more money than it gives out, it will act as a brake on

the economy, slowing it down Foreign households and firms enter the domestic circular flow model when exports and

imports are included Exports are an injection


Firms

Exports

Households

Government

Imports

Foreigners inject financial resources into the economy in exchange for goods and services

Imports are a leakage Foreigners extract financial resources from the economy as payment for goods

and services Households and firms also interact with financial intermediaries

Households save money in financial intermediaries and receive small payments of interest in return

Savings count as a leakage Firms borrow money from financial intermediaries for investment purposes

For the privilege of borrowing, firms make large payments of interest to the financial intermediaries

Firms’ investment is counted as an injection In the illustration below, arrowheads show the direction of the flow of money

The Circular Flow Model

Factor Markets

Financial Intermediaries

Product Markets

Economic Growth Overview

Economic growth is an increase in real GDP Essentially, an economy grows when it is able to produce more Growth can be seen as an increase in total output or as the outward expansion of the

PPF of an economy An increase in nominal GDP does not necessarily mean that an economy has grown

If prices are increasing (inflation), then nominal GDP can increase without real GDP ever increasing

If prices are decreasing (deflation), then nominal GDP can decrease even if real GDP actually increases

Economic growth is measured by changes in real GDP To obtain accurate measurements, nominal GDP must be converted to real GDP

The business cycle The economy alternates between periods of growth and decline, as indicated by the

business cycle The business cycle represents the cyclical fluctuations in total output, or real GDP,

that most economies experience Though the business cycle features periods of growth and decline, the general trend of

the entire cycle is upwards On average, the economy grows over time

Expansion (or upturn) occurs when the economy shows an increase in real GDP


Expansion is only recorded when growth has persisted for at least two consecutive quarters (six months)

Expansion continues until the economy reaches a peak A downturn occurs after the economy has peaked

Real GDP declines A recession occurs when the economy experiences a persistent downturn

Recessions are recorded when a downturn has persisted for at least two consecutive quarters (six months)

If a recession lasts for three quarters (nine months) or more, it is known as a depression

Because of the negative connotation associated with this word, however, it is rarely used

Recessions continue until the economy reaches a trough, after which the economy begins to expand again

The National Bureau of Economic Research defines a recession as “a significant decline in economic activity spread across the economy, lasting more than a few months, normally visible in real GDP, real income, employment, industrial production, and wholesale-retail sales”94

Most governments work to moderate the business cycle through policy

Peaks are dampened to prevent inflation and to ease future downturns Troughs are dampened to reduce social problems (such as unemployment)

Below is a brief history of the major events in the U.S. economy The longest economic decline in United States history resulted from the Panic of

1873 The economy reached a trough in 1879 This downturn was sparked by events in the international economy, namely the

collapse of the Vienna Stock Exchange The world economy was in a state of decline from 1873 to 1896

The Great Depression began with the collapse of the New York Stock Exchange in 1929

The United States’ economy reached a trough in 1933 A second recession took place in 1937, ending in 1938

An OPEC embargo resulted in oil shocks which contributed to a recession from 1973 to 1975

Trough

94 NBER, http://www.nber.org/cycles.html.

Expansion

Downturn

Real Output

Time

Peak The Business Cycle


The longest expansion in US history took place from 1991 to 2001 The most recent recession in the US economy occurred following the bursting of

the “dot-com” bubble, from the first quarter of 2001 to the fourth quarter of 200195 Other than the 1990s, most expansions in US history have resulted from, or

coincided with, wars96 Tracking economic growth

Economic growth can be tracked in a variety of ways besides monitoring real GDP Leading economic indicators give us a glimpse of real-time changes in the economy

Examples include current housing construction, changes in firm orders for resources, and stock prices

All of these can be monitored in real-time as events are happening, allowing for quick insight into economic change

Such indicators are sometimes faulty because they can be affected by short-term swings that have little impact on the long-run growth of the economy

Leading indicators give us a general idea of the future status of our economy Concurrent economic indicators give us a sense of general economic activity

Examples include employment, producer output, and net exports These indicators take a bit more time to compile than leading indicators but still are

available fairly quickly Concurrent indicators tell us how our economy is doing right now

Lagging economic indicators provide a more in-depth analysis of economic development

Examples include factor costs (such as unit labor costs) and even GDP itself These indicators take a great amount of time to put together but provide the most

accurate look at economic activity Lagging economic indicators help us see how our economy has performed in the

recent past Other tracking methods

A variety of other methods are also used to track growth in the United States The Department of Commerce publishes the Index of Leading Economic

Indicators to track 12 economic indicators that measure growth and development The Index of Consumer Confidence is a survey of 5000 households that tracks

confidence in the economy This index can reflect the future economic decisions of households and, thus,

prospects for growth Efficiency criteria: Pareto and Kaldor-Hicks

Pareto efficiency is the first criterion for determining whether or not an economy is performing efficiently

An economy has achieved Pareto efficiency if no one person’s welfare could be improved without detracting from the welfare of another

Pareto efficiency usually requires that the given economy is using all the resources at its disposal

If some resources are idle, firms or individuals can utilize them to produce more without taking away what is available to others

Pareto efficiency is determined using the pre-existing income distribution in an economy

95 For those who don’t remember this, the late ‘90s saw a huge expansion in the Internet. Companies sprang up left and right offering every service imaginable in an effort to capitalize on the Internet’s new profitability. In 2001, however, thousands of Internet businesses (“dot-com” business) went bankrupt, and the bubble burst. 96 Leading to the controversial belief of some that the US economy relies on wars for growth.


Kaldor-Hicks efficiency is the second criterion for determining efficiency An economy has achieved Kaldor-Hicks efficiency if it is getting the maximum possible

value out of its resources In other words, those who are harmed by the use of resources will demand a certain

amount of compensation If the economy is Kaldor-Hicks efficient, those who benefit from the use of these

resources are willing to compensate those who are harmed by the same amount This principle forms the theoretical foundation of cost-benefit analysis

Employment The labor force

The labor force of a given economy includes all members of the population who are employed or actively looking for work

Only adults (ages 16 and over) who are not incarcerated (in jail) can count as part of the labor force

The percent of the eligible population of an economy which is in the labor force is known as the labor force participation rate (also sometimes, activity rate)

One is only counted as participating in the labor force if one is either employed or actively looking for work

Discouraged workers are persons not in the labor force who want to work but who have given up looking for a job because they believe there aren’t any available97

Discouraged workers are not counted as part of the labor force These workers are also called marginally attached workers

In a time of greater prosperity, they would probably be actively seeking a job or working

They are barely “attached” to the economy and the prospect of having a job Housewives, retired persons, children, those serving in the armed forces, and other

individuals not looking for work are not counted as part of the labor force In the United States, the current participation rate is 67%98

A critical factor impacting the participation rate is the number of women in the workforce

The entry of more women into the workforce over the last half-century has significantly increased the participation rate in the US

Unemployment The employment rate is the number of persons employed divided by the labor force

As of May 2005, the employment rate for the United States was 94.9% Also as of May 2005, the total number of persons employed was 141.5 million

people The unemployment rate is the number of persons unemployed (but still in the labor

force) divided by the labor force As of May 2005, the unemployment rate for the United States was 5.1% Again as of May 2005,99 the total number of unemployed persons in the United

States was 7.6 million people The number of unemployed persons in a given economy is equal to the number

of people in the labor force minus the number of people who are employed

97 Definition from the Bureau of Labor Statistics. 98 According to USAD. 99 This was a big month for statistics. – Patrick


Adding the employment rate and the unemployment rate should always yield 100%

In fact, another way of defining the labor force is the total number of people employed and unemployed

An individual who is neither employed nor unemployed is not part of the labor force

Types of unemployment Unemployment is generally categorized in four ways Structural unemployment is unemployment which results from changes in the goods

that consumers demand or changes in technology For workers experiencing structural unemployment, the rest of the economy may

be in perfect health while they are out of work There are simply not enough jobs in a specific market for the number of

workers who want jobs Structural unemployment is ultimately due to a mismatch between the skills a

worker possesses and the skills demanded by the market Structural employment can also be the result of being in the wrong place at the right

time Let’s assume that new jobs are being created in Los Angeles, California, but not

in Helena, Montana If Unemployed Ursula were in L.A., she would probably be employed Since she’s stuck in Helena, though, she’s structurally unemployed

Structural unemployment can only be reduced by retraining workers for new jobs or by relocating workers to areas of the economy where jobs are being created

For example an unemployed steelworker in Ohio would have a job if he could learn how to code software or if he could move to Texas

Three laws of note have been passed to combat structural employment by training structurally unemployed workers with new skills

These three laws are the Manpower Training and Development Act (1962), the Comprehensive Employment and Training Act (1973), and the Job Training Partnership Act (1982)

Cyclical unemployment is unemployment which results from changes in the business cycle

If the economy is in recession, unemployment should be above normal If the economy is growing, then unemployment should be lower than normal Cyclical unemployment is the most serious type of unemployment because it

indicates a problem in the economy Frictional unemployment is unemployment which results from looking for work

Frictional unemployment results from the time-lag between when a worker is fired or quits his or her job and when he or she find a new job

Job searching, applying and interviewing for jobs, and relocation are among the reasons for frictional unemployment

Frictional unemployment can never be eliminated because some time lag will always exist between leaving one job and finding another

Time lags can be reduced, though, by ensuring that a dynamic and flexible labor market exists so that new jobs are readily available

Seasonal unemployment is unemployment resulting from jobs that fluctuate with the seasons

When seasons change, seasonal jobs become redundant and workers lose their jobs temporarily

Seasonal unemployment will always exist


There will forever be little demand for Santa Clauses in July and for ice cream salesmen in January (at least if you live in Michigan)100

A classic example is the unemployment of lifeguards during winter Seasonal employment can be dealt with through worker training to ensure that

workers have skill-sets that allow for year-round employment For example, we could train all the Santa Clauses to be ice cream salesmen

during the summer to ensure that they are working year-round Seasonal unemployment is the least serious type of unemployment because it occurs

regularly and is somewhat inevitable Natural unemployment

For all economies, a natural rate of unemployment is said to exist The natural rate of unemployment is the unemployment rate which exists in an

economy at full employment Unemployment can never drop below its natural rate (at least, not for long)

When unemployment drops below its natural rate, firms are competing fiercely for workers

To attract new workers, firms will have to increase wages (or other benefits), which increase labor costs

As labor costs increase, the price of goods will also increase, resulting in increasing inflation

The natural rate of unemployment can thus be described as the level of unemployment that corresponds to no inflation

Even when the economy is at full employment, some types of unemployment are inevitable

Frictional unemployment will always be present to some degree as workers switch jobs

Frictional unemployment is the main component of natural unemployment Structural unemployment is also a component of natural unemployment Seasonal and cyclical unemployment should be negligible in a perfectly healthy

economy The natural rate of unemployment for any economy is the overall unemployment rate

minus cyclical and seasonal unemployment To recap, an economy at full employment has only natural unemployment

The natural rate of unemployment is often described as the sustainable rate of unemployment, since any lower levels would result in inflation

Lower levels of unemployment (high levels of employment) would make the labor market fiercely competitive, driving up wages and costs

The result would be inflation The relationship between unemployment and inflation is described by the Phillips

Curve, which shows the two to be inversely related As unemployment decreases, inflation increases

The short-run Philips Curve expresses this relationship The long-run Philips curve, however is vertical

It shows that, in the long run, the natural rate of unemployment is more or less constant and independent of inflation (changes in the price level)

Previously, the natural rate of unemployment for developed economies was believed to be between 5.5 and 6%

100 I live in SoCal. Not only can I eat ice cream in January, I can go surfing too! – Zac


The long period of economic growth in the United States from 1991 to 2001 when

unemployment repeatedly fell below 5.5% but inflation remained stable, called this conclusion into question

Economists now recognize that the natural rate of unemployment for any economy can vary significantly depending upon a variety of technological and demographic factors

Money The characteristics of money

Money is an object or thing which is accepted as payment for goods and to settle debts Money should have five qualities to be useful for exchange

Money should be acceptable to most, if not all, parties of potential transactions It should be durable and, thus, able to be used in multiple transactions It should be portable and, therefore, easy to carry and use on an everyday basis Money should be adequately divisible

There should be different bills, coins, etc. of different amounts For example, eight quarters are considered equal to two one dollar bills

Money should be scarce enough that it is not worthless Conversely, it should also be widespread enough that transactions can always be

completed using money Money replaces barter as a means of acquiring goods

Barter is the trade of goods for other goods Remember, barter is inefficient because it requires a double coincidence of wants Barter also inhibits the division of labor

Because bartering is so cumbersome, individuals will attempt to become more self-sufficient to avoid having to trade

The functions of money Money has three distinct functions

As a medium of exchange, money replaces barter as a means of acquiring goods One exchanges money for goods

As a unit of account, money helps to establish the value of goods The pricing of items in monetary terms allows us to compare the relative values

of different goods This function of money as a standard greatly simplifies economic decisions Otherwise, it would be extremely difficult to compare goods

If one hammer is worth ten eggs and one shovel is worth five AA batteries, which is more valuable?

Unemployment

Short-Run Philips Curve

Natural Rate of Unemployment

Inflation

The Philips Curve

Long-Run Philips Curve


As a store of value, money allows economic worth to be preserved over time Goods lose value, or depreciate, over time Money retains its value and can be stored away with the knowledge that it can

later be used to purchase goods with just about the same purchasing power Note that inflation and deflation undermine money’s ability to serve as a store of

value Gresham’s law

Thomas Gresham was an advisor to Queen Elizabeth I of England Gresham’s law examines the relationship between “inferior” and “superior” forms of

money When “good” and “bad” money are in circulation, “bad” money forces out the

“good” money People will generally hold on to “good” money and will spend “bad” money to

get rid of it101 Gresham’s law originated with discussions of debasement

Back in medieval DecaLand, for example, all coins were made of silver The benevolent King Dan was very careful to ensure that all coins were valuable

and had a high silver content His successor, the King George the Glutton, wanted to promote his own wealth

and decided to debase the coinage He instructed the mints to lower the silver content of all new coins so that

more coins could be made from the same amount of silver This, by the way, is the definition of debasement: lowering the precious

metal content of coins in order to make more of them from the same amount of the precious metal

Before anyone found out about the lowered silver content, George spent the large number of silver coins on improvements for his castle

Soon, however, the denizens of DecaLand discovered that George’s coins were actually debased in value

Naturally, people held onto the “good” coins of King Dan’s era because these coins had more silver and, thus, were more valuable

Whenever anyone received one of the “bad” King George coins, he or she spent it as quickly as possible

Eventually, no good coins were in circulation anymore because people only spent bad coins

In other words, the bad money forced the good money out of circulation Commodity and fiat money

Money can be based upon either commodities or fiat Commodity money is money which takes the form of a usable commodity

Money is made from, or is represented by, usable commodities which can either be used as money or used for their own purposes

The most important examples of commodity money are precious metals, particularly gold and silver

Commodity money gets its value from what it is made from Gold coins have value and can be used in exchange because the gold they are

made from is itself valuable Fiat money is money which gets its value from legal decree

101 For example, I have a small collection of two dollar bills that I’m convinced will be valuable some day. I would much rather spend two one dollar bills (“bad” money to me) than one two dollar bill (“good” money to me). – Dean


Fiat money has no intrinsic or useful value on its own Its only use is as money102

Fiat money is valuable just because the government that prints it promises to back or support that money

All major economies now use fiat money The money supply

The money supply is the stock of liquid assets in a given economy which can be exchanged for goods

Liquidity is how easy it is to transfer, spend, move, or otherwise use an asset, such as money

The liquidity of a given asset is typically defined as how easily one can convert that asset into currency

Money can take a variety of forms Currency is money in the form of paper or coins which is used in everyday

transactions Currency is the form of money with which we are most familiar Currency can be made from a particular commodity, backed by a commodity, or

based purely upon fiat In early America, the government would exchange currency for silver

Currency is the most liquid form of money Demand deposits consist of money stored in accounts at banks103

Demand deposits can be withdrawn at any time without prior notice Typically, demand deposits are checking accounts

Time deposits also consist of money stored in accounts, typically at banks Time deposits differ from demand deposits in that time deposits cannot just be

withdrawn at any time Time deposits usually cannot be withdrawn for a predetermined period of

time Examples of some time deposits include some types of savings accounts and

certificates of deposit (CDs)104 Money market accounts are another form of deposits that have a variety of

restrictions Money market accounts typically require a larger initial deposit in exchange for

higher returns on that deposit Money market accounts usually limit the number of transactions their owners

can make in a given time period (usually a month) Money markets also require owners to keep larger balances to maintain higher

interest payments on deposits Other forms of money include traveler’s checks, some types of liabilities, and

Eurodollars Eurodollars include all dollar accounts held outside of the U.S.

These accounts can be anywhere, not just in Europe Credit cards and similar devices are NOT considered money

There are several different definitions of the money supply

102 In post-WWI Germany, money was so worthless (due to massive inflation) that people actually started using money for purposes other than spending. For example, many used bills as kindling for fires. Normally, though, the only use of money is to spend (not burn) it. – Dean 103 These different types of deposits and accounts are all examples of savings accounts. 104 If you are unfamiliar with CDs, they basically offer you a better interest rate on your money in exchange for your guarantee that you will not withdraw it for a given period of time.


Definitions of the money supply usually differ from one another based on liquidity The monetary base is the narrowest possible definition of the money supply,

including only coins and paper currency These are the most liquid forms of money It includes all currency held by the general (non-bank) public and that in bank

vaults M1 is restricted to extremely liquid forms of money but is slightly more inclusive

than the monetary base It includes currency in the hands of the public, traveler’s checks, demand

deposits, and other deposits against which checks can be written M2 is a slightly broader definition of the money supply and includes some less liquid

forms of money M2 includes everything in M1 plus savings accounts, time deposits of under

$100,000, and balances in money market mutual funds Time deposits under $100,000 are considered “small”105

M2 is less liquid than M1 but includes forms of money which are still useful for everyday transactions

Many economists consider M2 the best definition of the money supply M3 is an even broader definition of the money supply which includes substantially

more illiquid forms of money M3 includes M2 plus “large" time deposits (over $100,000106), balances in

institutional money funds, repurchase liabilities issued by depository institutions, and Eurodollars held by U.S. residents

M3 includes assets or forms of money which are nowhere near as liquid as the items included in M1 and M2

M3 and broader definitions capture assets which are more conducive to saving than to exchange

The Federal Reserve discontinued its use in March 2006 L is the broadest definition of the money supply used in the U.S.

The Federal Reserve officially discontinued its use in 1998 It includes M3 plus commercial papers, deeds, etc.

Broader definitions of money also exist The United Kingdom, for example, measures five different definitions of money

Relating the money supply to total output and prices

The money supply times the number of times money is used, should be equal to the output in the economy at current prices

The quantity theory of money states that MV = PQ (or sometimes, PT or PY) This equation is also known as the equation of exchange

105 I’d like a “small” time deposit for college… – Lawrence 106 And I’d like a large one. – Patrick

Most Liquid Least Liquid

Monetary Base

M1

M2

M3

Continuum of Measurements of the Money Supply

L


M is the stock of money or money supply (how much money exists)

M is determined independently of the other variables In other words, it is an independent variable in the equation

V is the velocity of money, or how often money circulates through the economy In other words, velocity is how often a dollar bill is spent in a given period V is considered to have a constant equilibrium value

It varies over time but will always average out to its equilibrium value Q (or T or Y) is the output of goods and services

Q is said to be given: real output at a given point in time is fixed Note that P x Q = GDP = M x V

P is the average current price level P is the dependent variable in the equation

It is influenced by the other three Since V and Q are fixed, changes in P are directly dependent upon changes in M

The equation basically states that the amount of money spent equals the amount of money used

It also shows that, given V and Q as constants, increases in M (the money supply) will result in increases in P (inflation)

Keynes attacked the early neo-classical version of the quantity theory of money, but it was reborn (in a far more complex form) in the work of the late Milton Friedman

The ultimate implication of the quantity theory of money is that creating more money results in inflation

The demand for money Money is generally valued and demanded for purchases of other goods

People do not generally demand money for money itself If people valued money itself, they would liquidate their assets (homes, cars, possessions,

etc.) into money rather than holding these assets Money can, nonetheless, be demanded for a variety of reasons

Money is demanded to make immediate transactions, to be prepared for unexpected expenditures, and to store wealth

The demand for money directly impacts interest rates

Inflation General information

Inflation is a sustained rise in the general price level If an economy is experiencing inflation, the prices of all market goods are increasing

over time The rate of inflation is the rise in the price level per unit of time

In the United States, most official measurements of inflation are by quarter A quarter is equal to three months (a quarter of a year)

Inflation decreases the value (purchasing power) of money Inflation weakens money ability to serve as a “store of value” because it erodes

money’s value over time As inflation continues, more and more money is needed to buy the same goods

Inflation can occur at varying speeds “Constant inflation” means that prices are increasing at a constant rate, such as

2% per quarter Remember that a quarter is three months long


“Disinflation” means that the rate of inflation is slowing down From the first quarter to the second quarter, for example, inflation could

decrease from 4% to 3% Disinflation is NOT the same thing as deflation

Deflation is a sustained decline in prices Basically, the value of money increases as prices decrease

It is usually a result of a drop in the money supply “Accelerating inflation” means that the rate of inflation is increasing

Acceleration inflation is essentially the opposite of disinflation From the first quarter to the second quarter, for example, inflation could

increase from 3% to 4% “Hyperinflation” is a term reserved for extremely high rates of inflation

Inflation above 20% is generally (but not always) considered hyperinflation This percentage is more of a loose guideline than a concrete rule

The most notable historical example of hyperinflation occurred in Germany after World War I

In 1920, the price of a one pound loaf of bread cost 1.2 marks By November 15, 1923, the same loaf of bread cost 80 billion marks107

The same ideas also apply to deflation One seldom hears them in this context because deflation is very rare

Types of inflation Inflation can result from changes in demand, supply, or the money supply Demand-pull inflation occurs when a sustained rise in aggregate demand results in a

rise in the general price level As demand grows, firms begin to reach their production capacities As demand continues to increase, producers are eventually unable to increase

production Instead, they will raise prices Increases in the prices of goods results in increases in factor prices, especially wages

When prices rise, workers demand higher wages to maintain their current standard of living

This process results in a general rise in the price level of the economy One can say that demand “pulls up” prices

The classic explanation: “demand-pull inflation is caused by too many dollars chasing too few goods”

Cost-push inflation occurs when an increase in production costs causes a sustained rise in the general price level

Cost-push inflation results from higher factor costs Demands from workers for increased wages is one potential cause Sudden resource shortages can also lead to factor price increases which increase

production costs Oil embargoes or increases in the price of crude oil can drastically increase

production costs The increased cost of factors results in a decrease in aggregate supply

The result is higher market prices In the 1970s, cost-push inflation led to the United States’ famous period of

stagflation Inflation can also occur if governments produce too much money

107 Seriously. I’m not making this up. – Dean


Expansionary monetary policy by governments results in an increase in the money

supply Increased amounts of money in the economy results in the same problem as in

demand-pull inflation: too many dollars chasing too few goods Inflation due to increases in the money supply can result from excessive deficit-

spending by governments or deliberate policy to boost aggregate demand Except for instances of cost-push inflation which result from outside factors, most types

of inflation can be attributed to a nation trying to “live beyond its means” Costs and benefits of inflation

Inflation decreases the real income of workers Wages are unable to sustain the same standard of living as prices increase Employers actually benefit in times of inflation

The wages they are paying out are not worth as much as they were before Inflation is a disincentive to save

If prices keep increasing, people will be less willing to save if the rate of inflation is higher than the returns to their savings (interest)

Inflation leads to price uncertainty for firms, which hurts the ability of firms to plan for the long-term

The inflation of domestic prices can undermine the competitiveness of a country’s exports

Inflation results in menu costs Firms must continually update price information (“change the menu”) to reflect

changing prices Inflation also creates shoe leather costs

Individuals (or firms) go to banks more often to withdraw deposits because the money they have in their pockets is suddenly worth less

This consequence is called the “shoe leather” cost because people’s shoes wear out from walking to the bank so often (figuratively, of course)

Tax payers also suffer from bracket creep, also known as fiscal drag Let’s say, for example, that Taxpayer Todd works in a factory If inflation hits the economy, Todd’s wages will probably increase as workers

demand more money to meet higher prices Todd’s nominal wages, therefore, will increase

His real wages, however, will probably stay the same (if not decrease) If inflation is bad enough, Todd’s nominal income may increase by enough that he is

bumped into a higher income tax bracket Because he supposedly makes more money, he now has to pay more taxes even

though his real income hasn’t increased Since the prices of all goods are increasing, his nominally increased wages really

can’t buy any more goods than before Todd has experienced bracket creep The federal government benefits from bracket creep because it receives more

money in the form of income taxes Inflation hurts lenders (creditors) but helps borrowers (debtors)

Inflation makes money less valuable Consequently, inflation decreases the real value of a loan over time

The amount the borrower pays back is worth less than it would have been without inflation

The lender does not get as much real money back as he or she should


Measuring inflation

The Consumer Price Index (CPI) is the method of measuring inflation most often used by governments

In the US, it is calculated by the Bureau of Labor Statistics The CPI works by comparing the prices of a given basket of goods between the

current year and a base year The CPI basket includes the sorts of goods which an average household would

buy on a regular basis The main component is housing

For the CPI to work, the variety and quantity of individual items in the basket must be fixed

Changing the make-up of the basket of goods from year to year would make comparing changes in prices between two or more years impossible because the comparisons would be between different goods

The CPI is in the base year is always 100 The number represents a percentage A CPI of 150 would mean that prices are 50% higher than in the base year A CPI of 90 would mean that prices are 90% of what they were in the base year

In other words, prices have gone down by 10% To calculate the rate of inflation, find the percent change in two CPI measurements

−= ×

1 0

0100

CPI CPIInflation

CPI

CPI0 and CPI1 represent the CPIs for the base year and current year, respectively The CPI is calculated by the Bureau of Labor Statistics, which also determines the

make-up of the basket of goods The market basket is established by surveys of households The CPI for April 2005 was 194.6, with 1982-1984 serving as the base period

The CPI has some advantages It captures changes in price for basic consumer goods, which form one of the

largest (and most important) parts of aggregate demand Given CPIs, the inflation rate is relatively easy to calculate

The CPI also has some shortcomings Over time, changing consumer demands, technology, or other factors may

render the fixed basket used for the CPI inaccurate or irrelevant For example, VCRs were a significant consumer good ten years ago but are

not so important today due to the emergence of DVD players The CPI does not account for the substitution effect

If one good in the basket becomes too expensive, consumer may switch to a substitute good

The fixed nature of the CPI does not account for this possibility The CPI does not account for changes in quality

While the price of cars is certainly more today than it was 15 years ago, part of this increase is due to the use of more expensive (improved) technology

CPI can also be used to convert the dollars of one year into dollars of another year

× =1

0 1$ $0

CPICPI

CPI0 and CPI1 are the CPIs of the earlier and later years, respectively


$0 and $1 are the equivalent dollar amounts of the earlier and later years,

respectively Let’s assume the CPI in 1980 is 100 and the CPI in 2006 is 204

$20 in 1980 would be worth $40.80 in 2006: 20 x (204/100) = 40.80 An alternative to the CPI is the GDP deflator

The GDP deflator is a broad price index used to correct for price increases in nominal GDP

The GDP deflator allows us to convert nominal GDP to real GDP

= so Nominal GDP Nominal GDP

Real GDP GDP Deflator = GDP Deflator Real GDP

A GDP deflator of one indicates that there is no inflation A GDP deflator less than one tells us the economy is experiencing deflation A GDP deflator greater than one tells us that there is currently inflation108

The GDP deflator examines all goods in an economy (which can change widely from year to year), rather than a select and fixed basket of goods

The GDP deflator has some positive attributes It is able to adapt to changes in consumer taste and other developments which

result in a change in output It takes all goods into account, rather than just a small basket of goods

The GDP deflator also has some shortcomings It is very difficult to accurately calculate

As a result, it is only published once each year Consequently, it can’t track inflation very quickly

Like CPI, the GDP deflator fails to take changes in quality into account Though the GDP deflator presents a far more accurate picture of inflation across

the economy than the CPI, it is not suitable for guiding government policy because it takes too long and is too difficult to calculate

Interest and Interest Rates Interest rates

Interest rates are essentially the “price” of money

Money Market

Money Supply

Money Demand

Quantity of Money

Interest Rate

108 The GDP deflator is sometimes multiplied by 100. In this case, a deflator of 100 indicates no inflation or deflation. A deflator greater than 100 indicates inflation, and a deflator less than 100 indicates deflation.


For reasons which will be discussed later, the money supply curve in the US is

vertical, or perfectly inelastic In other words, an increase in the interest rate does not result in an increase in

the quantity of money circulating in the economy The “pure” interest rate is the interest rate which would have to be paid to borrow

money in order to undertake a risk-free enterprise In reality, the pure interest rate is never really encountered

Interest rates are increased above the pure rate to allow banks and other entities to earn profits from financial services

Additionally, interest for loans is often adjusted for the risk of projects in order to cover the potential risk of failure

The market rate of most interest is the prime rate The prime rate is the interest rate that banks charge to their most credit-worthy

customers Major banks almost always feature the same prime rate

Some economists believe that interest rates reflect the demand for money Money (in currency form) acts as a store of value, but it has an opportunity cost in

the form of the rate of return of other potential assets Deposits and other interest-bearing opportunities are the next-best alternatives to

hoarding money Speculation and other behaviors ensure that the rates of return (the market interest

rates) on financial assets are about the same Other economists believe that interest rates are determined by productivity and savings

Productivity refers to the earnings of potential investments Higher productivity of investments creates a greater demand for money

If economic agents believe they will profit from investments, they are more likely to want money to make those investments

As a result, the money demand curve (see graph above) shifts to the right, thus increasing the interest rate

Savings provide the funds for investments The intersection of curves representing the supply of funds (savings) and the demand

for funds (the productivity of investments) yields the pure rate of interest According to the loanable funds theory, the supply and demand of loanable funds

determines the interest rate Loanable funds are the money that one is willing to lend and another is willing to

borrow According to this theory, when the quantity supplied and quantity demanded of

loanable funds are equal, interest rates remain constant Supply represents the ability and desire of those with money to lend it Demand represents the ability and desire of those who need money to borrow

it As with traditional supply and demand graphs, we use the intersection of the

two curves to find the interest rate (see graph below) Interest rates change with shifts in either the supply or demand of loanable funds

The reasons for these shifts resemble the causes for shifts in the markets for regular goods and services


Supply of Funds (Savers)

Loanable Funds Market

Demand for Funds (Borrowers)

Quantity of Loanable Funds

Interest Rate

Real interest rates and nominal interest rates

Nominal interest rates are the interest rates one is charged for a loan or which one receives for a deposit

These rates are the market rates that we see everyday Nominal interest rates are the rates that actually appear in loan contracts

Nominal interest rates do not take changes in the price level (inflation or deflation) into account

Real interest rates are nominal interest rates adjusted for inflation The real interest rate is what debtors actually pay and what creditors actually earn

after inflation is considered The real interest rate is calculated by subtracting the current rate of inflation from

the nominal interest rate Real Interest Rate = Nominal Interest Rate – Current Inflation Rate When written as Nominal Interest Rate = Real Interest Rate + Inflation Rate,

this equation is known as Fisher’s Hypothesis or the Fisher Equation Due to inflation, real interest rates can even be negative

The result is a negative price of money For example, Borrower Barry takes out a one-year loan of $100 from Lender

Larry in January 2001 The nominal interest rate is 5%, but the rate of inflation is 10% per year

The real interest rate, therefore, is -5% (5 – 10 = -5) In January 2002, Barry pays Larry back the $100 plus $5 in nominal interest

Thus, Barry pays Larry $105 This $105, however, is equivalent to only $95.45 in 2001 dollars:

105 x (100/110) = 95.45 Barry has actually made $4.55 on his loan

The Role of the State in the Economy Public goods and free riders

The state works to provide public goods Public goods are commodities or services which, if supplied to one person, are available

to other persons at no extra cost Examples include national defense, paved roads, the police, and environmental

protection


In contrast, the owner/consumer of a private good can prevent others from having

access to that good In the ideal case, a public good has two features

It is non-rival One person’s consumption of a public good does not reduce its availability to

anyone else It is non-excludable

The provider of a public good cannot prevent anyone from using it A private good, on the other hand, is both rival and excludable

When one person buys a private good, he or she is essentially preventing anyone else from having it

That person has the legal right to limit others from having access to that good Non-excludability of public goods causes the free-rider problem

Those who supply public goods cannot limit public-good access to only those who have paid for them

Those who have not paid for a public good (or paid less than others) can still enjoy it

Someone who does not pay taxes, for example, can enjoy a federally funded national park even if he or she does not pay taxes

This illegal immigrant qualifies as a free rider Public goods are (ideally) provided as a result of public choice

Public goods can be financed through taxes Alternatively, members of a society can agree to voluntarily provide and pay for the

good This situation can also give rise to the free-rider problem

Imagine, for example, that Freeloading Felipe lives on a cul-de-sac For some reason, the cul-de-sac doesn’t have a streetlight, and the street

gets very dark at night Felipe’s neighbors decide that they should all chip in to buy a streetlight,

rather than waiting forever for the city to pay for it This streetlight will, of course, benefit all of the residents in the cul-de-

sac equally Felipe decides, however, that he doesn’t really want the streetlight, so he

refuses to pay for it The rest of his neighbors go ahead and buy the streetlight anyway The streetlight is now a public good Though Felipe had no part in financing it, he can’t be excluded from its

benefits Felipe is a free rider

The free-rider problem also occurs when one person uses a public good more than others do

Let’s assume that Lucky Laura just happens to live two blocks away from a fire station

Unfortunate Una lives several miles away from the station In the case of a fire to either house, Laura will certainly benefit more from the

fire department than Una will Thus, Laura (because of her location) can use more of the fire department (a

public good) than Una can Note that pure public goods are very rare


Public goods can also result in the tragedy of the commons109 Taxes

Most government activity is funded by taxation Taxation is one of the most significant government interventions in the economy

A tax is a compulsory charge or levy enacted by the government to raise revenue to provide (among other things) public goods and services

Taxes take two general forms Direct taxes are applied directly to individual wealth or income Indirect taxes are taxes on transactions, especially consumer purchases

Income tax is the most familiar form of direct tax Income taxes can be levied on the earnings of individual citizens or on the profits of

corporations (corporate profit tax) A flat income tax is levied at a universal rate on all individuals

For example, everyone pays 10% of their gross annual income Wealthy Wally, who makes $300,000 each year, pays $30,000 in income tax Needy Ned, who makes $12,000 each year, pays $1,200 in income tax

The flat tax is also referred to as a proportional tax A progressive income tax features lower rates for poorer members of society and

higher rates for wealthier members This type is the income tax system in the US today

Regressive income tax is the opposite of a progressive tax Rich persons pay a lower percentage of their incomes as tax than poor persons The most notable example of a regressive tax is the sales tax

The poor spend a larger portion of their income on consumption than the wealthy do

One benefit of income taxes (especially progressive taxes) is that they can help redistribute income more equally among the populace

Income taxes have several disadvantages Income taxes may tax savings twice

Income that is saved is taxed and then taxed again when interest or other payments are collected on those savings

Income taxes have been said to discourage work If additional wages earned are taxed, individuals will be less inclined to work This idea is highly disputed It was first proposed by Arthur Laffer110 and is graphically represented in

the Laffer curve (see graph below) The graph is sometimes presented with the axes switched—tax rate on

the horizontal axis, tax revenue on the vertical axis If the government sets the income tax rate at 0%, it will collect no revenue If the government sets the income tax rate at 100%, no one will have any

incentive to work (all wages go to the government) Consequently, the government will collect no revenue

Some rate between 0% and 100% must exist at which the government collects a maximum amount of tax revenue

Laffer assumed that this rate is 15%, though he never did any research to justify this number

109 Although this topic fits here thematically, USAD includes it in microeconomics in the Economics Outline. Refer to the Microeconomics section (page 61) for more discussion on this topic. 110 I suppose it would be ironic if he were a very serious individual. – Lawrence


This theory was often cited by Ronald Reagan as justification for his tax cuts It is still praised by supply-side economists

The Laffer Curve Tax Rate

100%

0%

Capital gains taxes are direct taxes levied on the appreciation (increase in value) of

investments Unlike income taxes, investments do not have to be liquidated into income to be

taxable A capital gains tax focuses on the increase in value of investments even if they have

not yet matured or been cashed in In the US, capital gains taxes are treated just like income taxes, with a few

exceptions Capital losses (which can offset capital gains) are not taxed Each individual over 55 is allowed to liquidate assets up to $150,000 without

taxes one time Wealth taxes are direct taxes levied on the net wealth of an individual

Unlike income taxes, wealth taxes focus on all of the assets of an individual, not just income

Income is generated yearly, but wealth persists The most common form of wealth tax is property tax, a tax on owned land

Owned land is a form of wealth rather than income: it is not generated yearly Property taxes are often used by states to help pay for public education

Sales tax is the most basic form of indirect tax Technically, a sales tax is levied on market transactions, typically as a percentage of

the retail price In the United States, single-stage sales taxes are levied when consumers purchase a

good111 In most other countries, value-added taxes are collected at each level of

production and distribution A value-added tax is levied on the difference between the market price of a good

(intermediate or final) and the cost of its production Sales taxes can be general, applying to all goods, or levied only on select goods

Many states, for example, exclude clothing and food from the sales tax An example of a selective sales tax is an excise tax

Excise taxes focus only on specific goods, such as alcohol, gasoline, or cigarettes

111 Note that sales taxes are levied by states and/or municipalities – not all areas have sales taxes.

Tax Revenue

15%


Excise taxes raise the effective price of specific goods to discourage consumers from buying and consuming them

An excise tax on alcohol, cigarettes, etc. is also known as a sin tax Sin taxes are also known as Pigovian taxes

Pigovian taxes aim to discourage behaviors which lead to negative externalities

Sales taxes can be economically costly, as they increase the price of a good above its equilibrium price

Corporate profit taxes112 apply only to corporations Simply put, a corporate profit tax is a tax on the earnings of a corporation

Additional taxes of note are export/import taxes, estate taxes, gift taxes, and taxes designated to support specific government programs

These taxes target narrower sections of the economy The estate tax is also known as the “death tax”

It is a tax on inheritance In the United States, several taxes are designed to fund specific programs rather

than entering into broader federal spending The payroll tax is a small tax on employers to support the general

administrative costs of welfare programs, especially Social Security This tax is taken from workers’ paychecks

Usage taxes are designed to support specific federal services and infrastructure, such as ports and highways

The burden of a tax is determined by examining the incidence of taxation The incidence of taxation falls upon the party who actually pays the tax

The incidence of taxation is determined by the elasticity of supply and demand If the elasticity of supply is greater than the elasticity of demand, it is easier

for the supplier to adjust to the tax As a result, the incidence of taxation falls on the consumer (demander)

If the elasticity of demand is greater than the elasticity of supply, it is easier for the consumer to adjust to the tax

The incidence of taxation falls on the supplier For example, let’s assume the government enacts a 10% tax on cigarettes

The goal of this sin tax would probably be to harm the cigarette industry by decreasing its sales

However, the demand for cigarettes is very inelastic: addicts will probably buy just as many cigarettes even if the price increases

Consequently, cigarette sales will probably not decrease very much Most consumers will simply pay more rather than buying fewer cigarettes

In this situation, the incidence of taxation falls on the consumer This time, let’s assume the government enacts a 10% tax on Coca-Cola

The demand for Coca-Cola is fairly elastic: most consumers wouldn’t mind switching to Pepsi if the price of Coke went up

As a result, Coke sales will probably drop drastically as many consumers buy Pepsi instead

In this case, the producer (Coke) bears the incidence of taxation in the form of lost revenue

Taxes also result in deadweight losses

112 Otherwise known as corporate income taxes. This term is also mentioned and bolded in microeconomics, but we bold it again here because we are now discussing it in the context of taxes (rather than in the context of corporations).


A deadweight loss is a loss in social welfare resulting from a policy (in this case, taxation) which produces no corresponding gain

Deadweight losses represent economic inefficiency because welfare is squandered In taxation, the deadweight loss comes out of consumer and producer welfare

surpluses Consider the graph below

Graphically, a tax serves to shift the supply curve113 to the left,114 decreasing equilibrium quantity and increasing equilibrium supply

“Supply” is the original supply curve before the tax “Supply (with tax)” is the supply curve after the tax Equilibrium shifts from point F to point E

As you can see in the graph, the tax captures part of both consumer and producer surplus

The loss in consumer surplus is represented by area ABEF The loss in producer surplus is represented by area BCDF

The revenue collected by the government (because of the tax) is equal to the quantity of units sold (Qt) times the price of each unit

Therefore, the revenue collected is equal to area ACDE Area EDF, however, is lost but not recaptured

It is part of the producer and consumer surplus taken by the tax but not part of the revenue collected by the government

This loss of welfare is the deadweight loss inflicted by the tax

Deadweight Loss

113 Actually, it’s irrelevant which curve you shift to the left as long as you know how to find the equilibrium quantity and price after (it’s a little different with the tax taken into consideration). For our purposes, however, we will shift supply. 114 In this case, the supply curve is actually shifting up (because the tax affects price, and the vertical axis of our supply and demand graph shows price). But we’ll stick with left/right terminology rather than up/down to avoid confusion.

Supply (with tax)

A

C

Price

Quantity

Demand

D

Qt

Supply

E

F B


The following pie chart shows the role of varying taxes in funding the 2000 Federal

Budget115

Social Insurance

Payroll Taxes

34%

Corporate Income

Taxes

10%

Individual Income

Taxes

48%

Other

4%

Excise Taxes

4%

Government regulation of markets and competition

The government also acts to promote and manage competition in the economy Competition policy generally consists of government measures to protect consumers

and social welfare by stimulating competition and limiting monopoly The government can promote competition through a variety of methods

It can remove barriers to entry and promote competitive markets It can target anti-competitive behavior and punish firms that partake in such actions The state can also regulate mergers and acquisitions among companies Lastly, it can regulate natural monopolies to protect the public interest

The Commerce Clause of the United States Constitution (Article 1, Section 8) gives Congress the power to regulate interstate (and international) commerce

The Commerce Clause is now very broadly interpreted It gives Congress regulatory power over almost everything Technically, just about anything can somehow impact interstate commerce

Thus, all of these acts are fair game for Congress to regulate116 Within the United States, other laws have been enacted to promote competition

In 1887, government legislation created the Interstate Commerce Commission (ICC), the first regulatory commission in US history

Originally, the role of the ICC was to regulate the railroads and protect farmers from their often abusive business practices

The agency was disbanded in 1995 Perhaps the most significant federal law regulating competition in the United States

is the Sherman Antitrust Act Passed in 1890, the Sherman Antitrust Act was originally aimed at labor unions,

which are, in fact, a type of monopoly

115 Adapted from http://www.gpoaccess.gov/usbudget/fy00/descriptions.html#c26. 116 The astute student and follower of current events will note that the Supreme Court based its decision on medical marijuana in June 2005 on the Commerce Clause of the Constitution. The abolition of “separate but equal” institutions was also based on the Commerce Clause.


The act’s first part outlaws collusive agreements (cartels) which restrain trade or unfairly reduce competition in the market

The second part of the act makes monopolies illegal The Clayton Antitrust Act (1914) covers mergers

Mergers which will result in monopolies are prohibited It forbids a member of the board of directors of one company to serve on the

board of directors of a competing company In other words, the act outlaws interlocking directorates for competing

companies It also prohibits tying contracts and bilateral monopolies

A tying contract is an agreement between a buyer and a seller to deal exclusively with one another

The buyer won’t buy from any other seller, and the seller won’t sell to any other buyer

A tying contract creates a bilateral monopoly A bilateral monopoly is a market with only one buyer and one seller

Further, it legislates against harmful price discrimination “Harmful” price discrimination unfairly reduces market competition

The main bodies in the United States that control competition policy are the Department of Justice’s Anti-Trust Division and the Federal Trade Commission (FTC)

The Wheeler-Lea Act (1938) gave the FTC the power to investigate unfair and deceptive business practices

It also granted the FTC the power to prevent false advertising For countries in the European Union, competition policy is now controlled by the

European Commission rather than by national governments Government promotion of equality and income security

The most significant ways in which the government seeks to promote equality and income security are through welfare and Social Security

Welfare and Social Security (among other programs) are significant examples of transfer payments

Again, transfer payments are payments of money to individuals from the government not in exchange for current goods or services

Welfare in the United States was originally rooted in the provision of assistance to the unemployed during the Great Depression117 but has expanded significantly since

The most significant welfare program in the United States following initial efforts during the Depression was the Aid to Families with Dependent Children (AFDC) program118

AFDC was launched by the Social Security Act of 1935 and is administered by the states and the US Department of Health and Human Services

AFDC was primarily aimed at families in need and provided extensive benefits with few strings attached

Welfare programs in the United States were reformed significantly by Bill Clinton at the request of Congress during the 1990s

The length of time families could receive benefits was limited New requirements concerning employment were enacted for those on welfare

117 Most Great Depression aid was part of Franklin Roosevelt’s New Deal programs and reforms. 118 Source: http://www.acf.dhhs.gov/programs/afdc.


In other countries, most notably the social-welfare systems of much of Europe,

benefits are very generous and widespread, with few requirements for those on welfare

This situation is, however, changing in many countries Welfare, though necessary in many instances, also acts as a perverse incentive

If welfare is generous enough and lasts as long as it needs to, individuals have no incentive to find a job

Social Security is a program in the United States aimed largely at providing income security for the elderly and the disabled

Social Security is basically a minimum public pension for which all workers in the United States are eligible, with a number of limitations and exceptions

Social Security began with the 1935 Social Security Act The Federal Insurance Contribution Act (1939) levied a tax on all citizens’

paychecks to finance Social Security, welfare, and Medicare Social Security is funded through payroll taxes, in which employers and employees

contribute funds to Social Security Rather than paying to take care of themselves, individuals pay into a general fund

which finances the needs of the current elderly (and disabled) Systems in which current workers pay for current beneficiaries are known as

PAYGO systems: people “pay as they go” until they retire For PAYGO-funded public pensions schemes to be successful, workers must

outnumber beneficiaries significantly to keep payroll taxes low Thus, populations must keep growing and stay demographically young in

order to meet this condition In many developed countries, demographic shifts are occurring: there are

significantly more elderly people (pension beneficiaries) than ever before Continuing increases in the population of beneficiaries will result in ever-higher

payroll taxes to keep public pensions such as Social Security “solvent” A program “has solvency” if it is capable of meeting its present (not to

mention future) commitments Unemployment insurance and benefits provide income security for workers who

have lost their jobs Unemployment insurance works to smooth transitions between jobs by temporarily

ensuring the welfare of workers and their dependents In establishing benefits, governments must make benefits large enough to provide

security to workers but small enough to encourage workers to find new jobs Additionally, benefits expire: workers can only receive unemployment benefits

for a certain period of time This time limit encourages them to find a new job as quickly as possible

Unemployment insurance is provided by both the federal and state governments in the United States

The Federal Unemployment Tax Act (1939) levied a small tax on employers to support the general administrative costs of the unemployment compensation system

The tax also finances half the cost of extended unemployment benefits (discussed below)

States fund their own programs through a variety of means Unemployment insurance has many forms

Extended unemployment insurance is offered during severe economic downturns to continue worker benefits after they normally would have expired


Trade Readjustment Allowances (TRAs) are a form of extended unemployment benefits which are offered to workers who have lost their jobs as a result of foreign trade

Disaster Unemployment Assistance (DUA) is provided to workers who have lost their jobs as a result of a disaster119

Additionally, unique unemployment benefits are extended to veterans and federal employees (in some instances)

The government’s other roles The government must provide, interpret, and enforce laws for an economy to function

properly The state may also sponsor research or other programs which, due to cost, private

individuals would not undertake The government can also overcome certain collective action problems which would

otherwise hinder normal economic activity Societal norms and standards constitute one key area in which the government acts

Simple things, such as declaring on which side of the road people should drive, ensure the proper functioning of an economy

If individuals had to decide such things on their own, life would be more difficult and inefficient (as well as somewhat dangerous)

The Employment Act (1946) set maximum employment, production, and purchasing power as official goals of the federal government

It also declared inflation to be a significant national problem which the government would attempt to fight

Trends in government spending since World War II120 Government intervention in the economy has increased substantially since the end of

WWII Just before the war, government spending in the OECD nations (discussed in next

section) averaged 20.7% of each nation’s total GDP In 1996, these same countries’ governments spent on average 45.9% of GDP

As of 2003, the United States federal government spends approximately 18.72% of GDP Note that this does not include spending of the state and local governments

In many European countries, government spending accounts for well over 50% of GDP More on government spending

Government spending in the United States is divided among the states and the federal government

It includes both mandatory (automatic) and discretionary expenditures The US federal government is responsible for most government spending in the nation

Federal spending includes several mandatory (automatic) programs whose funding is earmarked

“Earmarked” means that the money cannot be used for any other purpose These programs include welfare, Medicare, unemployment compensation, etc.

Non-mandatory (discretionary) federal spending comes from the General Fund Money from the General Fund can be used to fund anything from national

defense to transportation projects The General Fund budget for 2005 was $2.57 trillion

119 The official status of “disaster” is designated and announced by the president. 120 The percentages below are more food for thought than items that must be memorized. They have been included to give you a general sense of the level of government intervention in major economies.


Most federal discretionary spending goes to Social Security, defense, Medicare, Medicaid,121 and interest on the national debt

The expenditures of individual state governments make up the remainder of government spending

Most state revenue is collected from sales and property taxes, but most states now also collect an income tax

The federal government also gives money to the states State governments spend their budgets mostly on local services

Most funding goes to education, then to other social services and transportation Government spending has ballooned lately as a result of the recent recession and the

wars in Afghanistan and Iraq Note that spending in Afghanistan and Iraq is not a part of the defense budget

Instead, it is from special appropriations outside of the existing budget As a result, the federal budget in fiscal year 2005 was more than $2.57

trillion Deficit spending and resulting government debts are financed through government-

issued securities In the United States, these securities are primarily Treasury bonds which are then

sold to private individuals and the Federal Reserve – see Monetary Policy These bonds come due after varying lengths of time of up to 30 years By buying bonds, individuals are essentially purchasing shares of government debt

on the promise that such purchases will be repaid, plus interest Interest rates on government securities reflect inflation and investor confidence in

the government’s willingness and ability to fight inflation If investors are confident that the government will keep inflation low, they will

accept lower interest rates Lower interest rates will lead more people to purchase securities, providing a strong

incentive for the government to gain credibility in fighting inflation Savers demand higher interest rates if they think inflation will occur: inflation will

undermine the value of their savings

121 It’s important to note that Medicare and Medicaid are, in fact, different programs. Medicare is intended to provide help for the elderly. Medicaid does the same for the poor and the needy.


The following pie chart sums up government spending of the federal budget in 2000122

Social Security

22%

Non-Defense

Discretionary

17%

Medicare

11%Medicaid

6%

Other Means-Tested

Entitlements

6%

Net Interest

11%

National Defense

15%

Reserve Pending Social

Security Reform

6%

Other Mandatory

Spending

6% The Benefits and Costs of Government Intervention

The government and externalities123 The government can play a critical role in reducing or eliminating externalities Negative externalities, or costs which are not internalized, can be combated through

taxes or fines The actions of individual agents which result in negative externalities are normally

continued because these costs are passed on to other people (externalized) The government can intervene in these cases and impose costs on these agents for

such activities By internalizing external costs, the government can work to reduce (or even

eliminate) negative externalities Examples include fines for pollution or penalties for over-fishing

Positive externalities, or benefits to society which are not internalized by individual agents, can be increased through government subsidies

The actions of individual agents which result in welfare gains for society (positive externalities) are often given up because the agents do not receive all of the benefits

The government can intervene by increasing the benefits for individual agents, encouraging such beneficial actions

Examples include government funding for research and education or providing tax-breaks to people who buy fuel-efficient cars

The government and long-term plans Since governments do not operate in the hopes of making profits, they can take actions

which may result in short-term losses but which have long-term benefits An example is investment in public infrastructure (such as highways)

122 Adapted from http://www.gpoaccess.gov/usbudget/fy00/descriptions.html#c26. 123 See the Fundamentals section (p. 12) for a more complete discussion of externalities.


Infrastructure is very expensive in the short run but has significant long-run benefits Highways, for example, were very expensive at first but have allowed many cities

to grow and flourish The government and non-economic decisions

The government can make decisions based on non-economic grounds In some instances, non-economic decisions are good

Pollution restrictions, for example, may impose a cost on industries but be beneficial for the overall welfare of populace

However, decisions of the state can be especially costly when they are determined not by economics, but by the concerns of special interests groups

On one hand, special interests groups may be able to draw attention to problems which the market economy has been unable to deal with effectively

Many environmental groups, for example, lobby for environmental protection laws from the government

These groups often work to promote what they think is the public welfare On the other hand, special interest groups may also work to further their own

interests at the cost of the rest of society by advocating socially harmful policies For example, oil lobbyists are extremely influential and may try to decrease

government funding for alternative energy sources Equity and efficiency: a trade-off

One cost of government intervention may be that overall economic efficiency is sacrificed in exchange for increased equity (such as income equality)

One may argue, for example, that taxes on lucrative corporations discourage innovation

State action designed to promote economic growth or similar goals may also result in sacrificing equity

For example, tax cuts to businesses designed to encourage investment also promote the wealth of the upper-class owners of these businesses

State action must seek to balance the goals of maintaining equality in society while at the same time ensuring that economic growth and efficiency continue

Topics of recent policy debates Healthcare: the state can either provide benefits for people or let individuals take care

of themselves In the United States, current policy is to assist the needy (Medicaid) and the elderly

(Medicare) All other individuals are left mostly to themselves

The United States is the only developed nation in which more than half of all healthcare spending is within the private sector

Almost all other developed countries provide some form of healthcare coverage for the entire populace

Individuals in the US spend the most amount of money on healthcare in the world: an average of $5635 per person, totaling 15% of GDP124

The environment: the state can either actively protect the environment or let the market decide what level of environmental protection is desirable

Many believe that the state must intervene heavily to protect the environment This intervention will dramatically increase costs for firms which, in turn, will

increase costs for consumers Others believe that the market should decide on environmental issues

124 We’re number 1! USA! USA! Oh…wait… – Patrick


If consumers desire greater environmental protection, they will buy products

made in environmentally friendly ways, even if these products are more expensive

This issue is particularly relevant in developing countries Many developing countries often prefer to develop as quickly as possible, no

matter how much pollution is generated Developed countries usually prefer to see stricter environmental standards

Setting prices: the state may also intervene to control prices and wages Some believe the government should work to provide a “decent” standard of living

for all by controlling wages (through minimum wage laws) and prices of basic commodities (food, housing, etc.)

Others respond that such governmental price controls will result in shortages of the very same goods, thus defeating the original goal of welfare improvement

Fiscal Policy Overview

Fiscal policy is the use of government expenditures (and taxation) to influence the domestic economy

By spending money, the government can directly impact overall economic activity Increased government spending results in increased aggregate demand and, thus, higher

GDP Remember: C + I + G + NX = GDP = AD

C = consumption spending I = investment spending G = government spending NX = net exports = Exports – Imports = X – M

Automatic and discretionary policy Fiscal policy has both automatic and discretionary components Automatic elements of fiscal policy concern already-existing taxes and transfers designed

to counteract cyclical changes in the economy When the economy enters into recession, people will earn less

As a result, they will probably pay less money in taxes As income decreases, existing federal programs such as welfare and

unemployment benefits, will also compensate for the economic downturn All of these processes involve automatic increases in government spending which

will serve to counteract the repression Similarly, if the economy were growing too rapidly, increased individual taxes as

incomes rise would act as a brake on growth Additionally, federal spending on programs such as welfare will decrease, serving

to further decrease GDP Counteracting expansion limits inflation

Because automatic policies work to counteract cyclical change, they are known as automatic stabilizers

Automatic policy also includes several programs called means-tested programs To qualify for one of these programs, an individual’s income must be below a

certain level Following are some examples of means-tested programs

Temporary Assistance for Needy Families (TANF) Earned Income Tax Credit (EITC)


Supplemental Security Income (SSI) Medicaid Food Stamps

Discretionary elements are deliberate government programs enacted to fight an economic downturn or to prevent too rapid growth and accompanying inflation

These are the policies of most interest because they require governments to respond to cyclical changes in the economy

Most discussions of fiscal policy center upon discretionary fiscal policy The purpose of discretionary policy

Discretionary fiscal policy can either address a downturn or an out-of-control upturn in the economy

Both types of discretionary policy aim to reduce output gaps An output gap is the difference between the current level of activity in the economy

and the sustainable (full employment) level of activity in the economy When current economic activity is below the sustainable level of activity, a

deflationary (or recessionary) gap exists When current economic activity is above the sustainable level of activity, an

inflationary gap exists Sustainable activity/output is also referred to as potential activity/output To calculate output gaps, subtract actual output from sustainable output

Output Gap = Sustainable Output – Actual Output Deflationary gaps are positive while inflationary gaps are negative

Though this may seem counterintuitive, deflationary gaps are positive because actual output is less than sustainable output

Similarly, inflationary gaps are negative because actual output exceeds sustainable output

Gaps are almost never calculated in monetary terms, but rather as percentages For example, an inflationary gap could be 3% of sustainable output

Output gaps must be taken with a grain of salt, however, as it is impossible to determine the exact potential output of an economy

Graphically, an output gap is the distance between an economy’s short-run equilibrium and its long-run equilibrium

Short-run equilibrium exists at the intersection of short-run aggregate supply and aggregate demand

Long-run equilibrium exists at the intersection of long-run aggregate supply and aggregate demand

Fiscal policy designed to address a downturn (reduce a deflationary/recessionary gap) is known as expansionary policy

Expansionary policy seeks to boost economic growth and to reduce or eliminate a recession

When the government is conducting expansionary policy, it will increase federal spending and/or decrease taxes

Expansionary policy seeks to spark demand by putting more money in the hands of private individuals and firms

Income tax cuts increase individuals’ disposable income Increasing government spending channels money toward private firms

Fiscal policy designed to “rein in” an economy which is expanding too fast (reduce an inflationary gap) is known as contractionary policy

Contractionary policy aims to reduce economic growth to sustainable levels, mostly to avoid inflation and a potentially dramatic downturn in the future


When conducting contractionary policy, the government will decrease spending

and/or raise taxes Contractionary policy seeks to deflate an economy by reducing growth

Keynes Much of modern fiscal policy originates with the ideas of John Maynard Keynes, the

British economist mentioned in the first section His most important work is the General Theory of Employment, Interest, and Money Keynes’ work stressed that a pure capitalist economy cannot maintain full employment

and sustained economic growth on its own Instead, it requires government intervention

The focus of Keynes’ work (and most Keynesian policy) was on unemployment Many of his contemporaries argued that cutting wages during periods of high

unemployment would bring an economy out of recession by reducing the price of goods

Keynes disagreed: he believed that cutting wages would cut workers’ incomes and, as a result, reduce aggregate demand, worsening the recession

In Keynes’ model, the government should intervene during periods of high unemployment to increase aggregate demand by increasing spending

Keynes also introduced the idea of sticky wages125 Classical economists believe that markets are frictionless

In other words, firms and consumers will quickly respond to imbalances in an economy in order to restore it to equilibrium

Keynes pointed out that, in fact, wages are “sticky” in the downward direction Workers are reluctant to accept pay cuts, which can prevent aggregate supply

from effectively responding to a change in the market Multipliers: how fiscal policy works

Fiscal policy actually has a greater impact on the economy than the pure change in government spending and taxation

The impact of fiscal policy is determined by two factors: the marginal propensity to consume (MPC) and the marginal propensity to save (MPS)

If Worker Willy receives a $1 raise, the amount of that dollar that he spends is his marginal propensity to consume

The amount that he doesn’t spend (saves) is his marginal propensity to save In other words, an individual’s marginal propensity to consume is how much of each

additional dollar in income he or she will spend The marginal propensity to save is how much he or she will not spend (save)

These two statistics are written as decimals and always fall between zero and one They must always add up to one since all money received must be either spent

or saved MPC MPS 1+ =

If the government changes spending, the amount that spending influences the economy is determined by the spending multiplier

= =−

MultiplierMPC MPS1 1

1

The total impact on GDP is equal to the change in spending times the multiplier If the government changes taxes, the amount this change influences the economy is

determined by the tax multiplier 125 Also known as “rigid” or “inflexible” wages.


MPCTax multiplier

MPS−

=

The total impact on GDP is equal to the change in tax revenue times the multiplier The impact on GDP is opposite the change in taxation

An increase in taxes will decrease consumption and GDP A decrease in taxes will increase consumption and GDP This inverse relationship is why the tax multiplier has a negative sign in front

of it In order to finance an increase in government spending, the government sometimes

raises taxes by the same monetary amount as the increase in spending The resulting impact on the economy is determined by the balanced budget

multiplier The balanced budget multiplier is always equal to one

Balanced Budget Multiplier Spending Multiplier Tax Multiplier

MPC MPC MPSBalanced Budget Multiplier

MPS MPS MPS MPS1 1

( ) 1

= +− −

= + = = =

Multiply the change in spending (or in taxes, since the changes should be equal) by the balanced budget multiplier to determine the effect on GDP

Limitations of fiscal policy Fiscal policy has numerous limitations To fight a deflationary gap, the government must increase spending and/or decrease tax

revenues Fiscal policy is most needed at the same time that the government will take in less

money due to the economic downturn Expansionary fiscal policy almost always results in large government deficits during

periods of recession The national debt is the total amount of money owed by the government Government deficits consist of shortfalls in on-going budgets The national debt is essentially the sum of all deficits and surpluses in a nation’s

history Running deficits and increasing the size of government debt can increase interest

rates, which will result in less private investment as loans become more expensive This decrease in investment counteracts (to some degree) the government’s

expansionary policy This phenomenon is known as crowding out

Crowding out occurs whenever fiscal policy produces side-effects which reduce the overall impact of the government’s actions

Many supply-side economists cite crowding out as an argument against the Keynesian approach to manipulating aggregate demand through government spending

Deficits create a future fiscal burden by adding to a debt which will eventually have to be paid off

If the recession is brought about by a decrease in aggregate supply, fiscal policy can fuel inflation by increasing factor prices

Sudden decreases in supply are due to external events called supply shocks Supply shocks impact nearly all producers in a given economy An example of a supply shock is a sudden increase in the price of crude oil


A huge percentage of firms use oil as an input in their production

processes This inflation can reduce consumption (incomes are worth less), which decreases

GDP and aggregate demand This situation is another example of crowding out

Fiscal policy requires legislative action, as government spending is often controlled by legislatures

In the US, spending, appropriations, and budgetary decisions are made by Congress Congressional action can be very slow and, thus, incapable of responding to sudden

changes in the economy Fiscal policy, however, has a quick effect once implemented

Announcements of a certain policy action often have as much of an effect as the policy itself

For example, an announcement of a tax cut to take effect in the future often leads people to start spending more now, as if they had already received the tax cut

Fiscal policy is very broad and may result in the government taking improper action If the state thinks that the economy is overheated (when in fact it is not), increasing

taxes or reducing spending may end up causing a recession rather than gradually reducing an unsustainable expansion

Similarly, if the state misjudges a downturn, improper policies may result in a longer or more pronounced downturn

Monetary Policy Overview

Monetary policy is intervention in the economy through changes in the supply of money

By either restricting or increasing the supply of money in the economy, the state can impact a variety of economic activities

Monetary policy can be inflationary (increasing the amount of money) or deflationary (decreasing the amount of money)

A larger money supply leads to lower interest rates in the market Since more money is circulating in the economy, borrowers don’t have to

compete as much for loans Loaners lower interest rate to attract borrowers Lower interest rates encourage investment spending by firms and borrowing

by individuals (leading to more consumption) The result is a shift of the aggregate demand curve to the right

Inflationary monetary policy is also described as “loose” or “expansionary” A smaller money supply causes interest rates in the market to increase

Since there is less money going around, borrowers must compete more if they want to take out a loan

This competition allows loaners to raise interest rates to extract more profit Higher interest rates discourage investment spending by firms and borrowing

by individuals The result is a shift of the aggregate demand curve to the left

Deflationary monetary policy is also described as “tight” or “contractionary” In addition to changing the supply of money, monetary policy also affects (or operates

through) specific interest rates and exchange rates


Monetary policy can have three goals The first is price stability: ensuring that inflation is kept in check at a constant, low

rate The second is full employment: ensuring that all resources in the economy

(particularly and especially labor) are being utilized The third is economic growth: sparking the economy to expand Note that these goals cannot all be achieved at the same time

Inflationary monetary policy can bring about full employment and spark growth, but only at the cost of inflation (sacrificing price stability)

Central banks Monetary policy is most often conducted by a nation’s central bank Central banks are “bankers’ banks”: lenders of last resort which are responsible for

exercising control over the credit and banking system Central banks are also responsible for a number of other tasks

These tasks include controlling banknotes, accepting deposits from and making loans to private banks, acting as the government’s bank, and exchanging money with other central banks

Central banks play a pivotal role in the economy because the rate of interest charged on short-term loans to commercial banks forms the basis of all other interest rates in an economy

These loans are a last resort when banks cannot cover their liabilities They are known as “repo” or “overnight” loans

“Repo” is short for “repurchase agreements” Central banks can either be independent of the government or controlled as a policy

instrument of the government Independent central banks are generally seen as more credible fighters of inflation

and better executors of monetary policy as they do not face political pressures They can, however, be criticized as unaccountable and undemocratic

Government-controlled central banks are more responsive to public (and political) demands for full employment and growth

Consequently, though, they have a poor record of fighting inflation and may base policy not on economic goals but on political goals

Many central banks are now independent The most notable examples of such banks are the Federal Reserve of the US, the

Bank of Japan, and the European Central Bank of the European Union This last bank is based on the Bundesbank, Germany’s independent central

bank prior to the introduction of the euro The Bank of England, the United Kingdom’s central bank and the oldest central

bank in the world, became independent in 1998 The Federal Reserve

The Federal Reserve (Fed for short) is the central bank of the United States The Federal Reserve Act of 1913 created the Federal Reserve System as the central

bank of the United States126 Unlike many other central banks, the Federal Reserve System is, in many ways,

decentralized The Federal Reserve system consists of 12 districts, each with its own bank

Each district is identified by a number and the location of that district’s bank

126 Before the establishment of the Federal Reserve, the US relied on the Bank of the United States and later on a loosely organized system of national banks established by the National Banking Act (1863).


The districts are headquartered in Boston, New York, Philadelphia, Cleveland,

Richmond, Atlanta, Chicago, St. Louis, Minneapolis, Kansas City, Dallas, and San Francisco

Missouri is the only state with two Federal Reserve branches (in St. Louis and in Kansas City)

Within their regions, district banks have several roles They act as lenders of last resort They supervise banking practice and management Each Federal Reserve bank provides services (most notably check clearing) to

other banks in the area They also implement monetary policy as dictated by the Federal Reserve

Board Districts are also responsible for producing currency

A quick look at a dollar bill will show a letter inside the seal to the left of Washington’s portrait – this letter corresponds to the regional bank which issued the currency

There are 12 letters (A through L), one for each of the 12 districts of the Federal Reserve System

25 smaller branch banks also operate in the various districts District and branch banks are supervised and controlled by the Federal Reserve

Board in Washington, DC The Fed’s Board of Governors consists of seven governors who each serve a 14-

year term One term expires every 2 years These governors are appointed by the president and confirmed by the Senate

The chairman of the Board of Governors is the effective head of the Federal Reserve System and is appointed every four years

The current chairman is Ben Bernanke Prior to Bernanke, Alan Greenspan served as chairman for four terms

Monetary policy is chiefly exercised by the Federal Open Market Committee (FOMC)

The FOMC trades (buys and sells) government securities on the open market (discussed in more detail below)

The FOMC consists of twelve members: the seven members of Federal Reserve’s Board of Governors, the president of the New York District Bank, and the presidents of four other district banks

Each of these 12 members has the right to vote on FOMC issues and decisions Day-to-day operations in accordance with FOMC policy are conducted by the New

York District Bank One final committee worth noting is the Federal Advisory Council

This council has no policy-making role Instead, it serves as a forum for communication between commercial bankers and

the Fed The council consists of one commercial banker representing each district in the

Federal Reserve System Meetings occur once every quarter and provide a means for private bankers to

officially communicate with the Board of Governors Not all US banks are members of the Federal Reserve System Although the Federal Reserve is independent, it operates within or under goals defined

by legislation


Most central banks are charged with achieving either full employment or price stability

The Employment Act of 1946 established achieving full employment as a prerogative of the federal government, but not the Federal Reserve

The more extensive Full Employment and Balanced Growth Act of 1978 nominally extended full employment as a goal to be achieved by the Federal Reserve

In practice, however, it only demanded that the FOMC testify before Congress twice a year on monetary policy

It also set the natural rate of unemployment at 4% The act deemed any rate above 4% unacceptable, meaning that the

government will intervene if the rate is above 4% This act was nicknamed the Humphrey-Hawkins Act after its chief sponsors

More recently, the Mack-Saxton Bill (introduced in 1995 and again in 1997) would have made long-term price stability the primary goal of the Federal Reserve

Ultimately, the Federal Reserve does not have a specific operational goal but, instead, has great leeway

Other central banks, notably the European Central Bank, have very strict operational criteria concerning price stability

The European Central Bank works to keep year-to-year inflation below 2% The Fed’s three tools of monetary policy

The Federal Reserve uses three policy tools to conduct monetary policy Open-market operations are the primary, day-to-day means through which the

Federal Reserve, through the FOMC, conducts monetary policy Open-market operations are the buying and selling of government securities

(treasury bonds) To increase the money supply, the FOMC buys bonds from bondholders

Buying bonds takes securities out of the economy and injects money into it To reduce the money supply, the FOMC sells bonds

Selling bonds takes money out of the economy and replaces it with securities127 Adjustments to the discount rate and the federal funds rate by the Board of

Governors are the next most-utilized ways of conducting monetary policy The discount rate is the rate of interest which the Fed charges commercial banks for

loans Commercial banks will seek loans to meet cash shortfalls or to maintain reserve

requirements As the lender of last resort, the Federal Reserve acts as the bank for commercial

banks Commercial banks will only use the Fed as a last-resort source of short-term

credit Lowering the discount rate encourages commercial banks to make more loans

because borrowing from the Fed in case of a shortfall will be less costly Increasing the discount rate increases the cost of borrowing from the Fed, which

will discourage commercial banks from making as many loans The more banks loan, the more money is injected into the economy

Raising the discount rate decreases the money supply Lowering the discount rate increases the money supply

Additionally, the discount rate directly influences the interest rates banks charge to their customers, most notably the prime rate

127 A nice mnemonic for you: Buy Bonds = Bigger Bucks, and Sell Bonds = Smaller Bucks. – Lawrence


Again, the prime rate is the interest rate a bank charges to its best customers If the Fed lowers its discount rate, firms will often lower their prime rates

Lower interest rates encourage individuals and firms to borrow more money, further expanding the money supply

Higher interest rates discourage individuals and firms from borrowing, thereby decreasing the money supply even more

The Fed exercises direct control over the discount rate and can effectively set the rate as it wishes

Commercial banks, can, however, seek other sources of credit The federal funds rate is the overnight rate of interest charged on loans between

banks (“repo” loans) As with the discount rate, banks will loan more at a lower rate and less at a

higher rate More loans means more money in the economy

Unlike the discount rate, the Fed does not directly set the federal funds rate Instead, it can only influence it through market operations

Buying and selling government securities impacts the interest rate as well as directly influencing how much money is in the economy

Monetary policy through adjusting interest rates is, like fiscal policy, subject to crowding out

Increasing the money supply lowers the interest rate This decrease encourages more individuals and firms to take out loans The consequential increase in the demand for loans and funds serves eventually

to increase the interest rate This increase in the interest rate discourages individuals and firms from taking

out loans This interest rate increase is, however, less than the initial decrease The crowding out in this case is minor in comparison to the overall impact of

the monetary policy The final way the Fed can conduct monetary policy is by changing the reserve

requirement The reserve requirement (also known as the reserve ratio) is the percentage of

deposits which a bank must have on hand at any given time When banks loan money, the money is taken from deposits given to them by

customers If all deposits are loaned out depositors will be unable to withdraw their money

when they want to do so Additionally, if banks run out of deposits, banks can collapse and savers may lose

their money This situation happened to many during the Great Depression

Ensuring that banks always have a certain amount of money on hand means that depositors will always be able to withdraw their deposits

Making reserve requirements legally binding means that banks will always have to meet these requirements

If reserves dip below the required amount, banks have to borrow money from other banks or from the Fed to restore reserves to the required levels

This process is one way that changes in the discount and federal funds rates affect money supply

The impact of changes in the reserve ratio on the money supply can be measured through the money multiplier (MM)


The money multiplier is the inverse of the reserve requirement (RR)128

MMRR1

=

For example, if the reserve requirement is 20% of total deposits, then the money multiplier will be 5: 1 / .2 = 5

To calculate the impact of a new deposit in a bank on the money supply, multiply the amount of the deposit by the money multiplier

If the reserve ratio is 20% and someone deposits $1 million in a bank, the net result will be a $5 million increase in the money supply: $1 million x 5 = $5 million

Theoretically, the bank will loan out $800,000 (80%) of the initial $1 million deposit

Eventually, this $800,000 will all be re-deposited, either by the borrower or by others (such as firms that receive the money as payment for goods)

Of this $800,000 that is re-deposited, 80% ($640,000) will be loaned out again

The cycle continues on and on Eventually, the total impact on the money supply will be an increase in $5

million If the reserve ratio is decreased, banks have to keep less money on hand

Consequently, they can loan out more funds, increasing the money supply If the reserve ratio is increased, banks have to keep more money on hand

As a result, they can’t loan out as much money, and the money supply decreases Unlike open-market operations and changes in interest rates, changes in the reserve

requirement are initiated by the Federal Reserve’s Board of Governors, not the FOMC

The reserve requirement is not often utilized as a monetary policy tool because it alters the banking system, which can often create difficulties for banks

The reserve requirement is enabled by fractional reserve banking In a system of fractional reserve banking, banks keep only a fraction of their

deposits Depositors still own the money they have deposited in the bank, but banks can

loan this money to borrowers These loans essentially create additional money, increasing the money supply

Changes in the reserve requirement accelerate or hinder this activity

128 Math experts may notice that the money multiplier formula is an application of the sum of an infinite series.


MONETARY POLICY

Policy Tool Who Acts? What Happens? How Does It Work?

How Often Is This Tool Utilized?

Open-Market Operations

FOMC The Fed buys and sells US securities

Injects or removes money from the

economy Daily

Discount Rate Board of Governors

The Fed changes the interest rate for loans

from the Fed to member banks

Changes the cost of borrowing from the

Fed Rarely129

Federal Funds Rate Board of Governors The Fed changes

bank-to-bank lending rates

Changes the cost of loans between all

banks

Approximately once per quarter

Reserve Requirements

Board of Governors The Fed changes the reserve requirements

for banks

Changes the amount of reserves banks

must maintain Very rarely

It’s extremely important to note that the Fed does NOT change the money supply by actually creating new currency (printing new bills and minting new coins)

The creation of new currency requires special Congressional legislation Instead, the Fed changes the effective supply of money through the above measures

The graph below illustrates how monetary policy functions All of the monetary policy tools serve to increase or decrease the effective money

supply When the Fed uses one of these tools, the money supply curve shifts to the left or

right if the tool is contractionary or expansionary, respectively A change in the interest rate through monetary policy in turn influences the amount

of investment in an economy Expansionary monetary policy leads to lower interest rates, which is encouraging

for investment130 Remember that investment is a component of aggregate demand and GDP Expansionary monetary policy, therefore, works to increase GDP through

increases in investment Contractionary monetary policy, on the contrary, decreases GDP through

decreases in investment

129 Interestingly enough, the Fed has been changing the discount rate monthly ever since 2000. Before then, the rate changed much less often—about once or twice a year, if at all. 130 If this concept doesn’t make sense, think about car commercials—dealerships are always trying to entice consumers with promises of low interest rates. Yes, this example relates to consumption, but the concept is the same.


Monetary Policy Interest Rate

Investment Rates Interest Rate

Stagflation

Monetary policy is now the dominant way in which the US manages the economy Keynesian policies remained the basic tool for the United States to manage the

economy until the stagflation period of the 1970s Sharp increases in oil costs and debts from the Vietnam War resulted in a sluggish

economy Traditional Keynesian policies recommended boosting aggregate demand through

government intervention The government attempted such policies but only ended up increasing interest

rates substantially as the government ran ever-higher deficits Efforts also resulted in high inflation

Inflation led workers to demand pay increases to maintain their standard of living Wage increases only led to further inflation as factor prices for goods increased

The result was stagflation: simultaneous stagnation (little growth) and inflation Stagflation defied the fundamental concept behind the Philips curve: a trade-off

exists between inflation and unemployment An economy should experience one or the other (in varying degrees), not a

lot of both at the same time The long-run Phillips curve was suggested to account for stagflation

Stagflation would be equivalent to a rightward shift in the Philips curve: higher unemployment at all levels of inflation

Since then, monetary policy and monetarism (see below) have become more prominent Monetarists

Monetarists believe that reducing inflation should be the first priority of the government

They propose that growth will follow price stability Monetarists posit that any change in aggregate demand created by the government

will ultimately result in higher inflation The money supply should only grow with increases in real output

Increases above growth in real output will only result in inflation Monetarists place great emphasis on the quantity theory of money (MV = PQ)

In addition to maintaining price stability, monetarism emphasizes that supply-side measures are the only path to true economic growth

Like monetarists, supply-side economics rejects government intervention and Keynesian stabilization policy

Quantity of Money

Money Demand

Money Supply

Investment Demand

Quantity of Investment


They also believe that these measures only increase prices (not real output) in

the long run Supply-side economics instead emphasizes increasing the real output of the economy

It advocates tax cuts and subsidies to businesses to increase aggregate supply Increases in aggregate supply lead to lower price levels and higher output

simultaneously President Ronald Reagan advocated supply-side economics and tax-cuts for

corporations He hoped that the resulting increases in corporate spending would cause the

benefits of these tax-cuts to “trickle down” to the middle classes As a result, Reagan’s economic policies were nicknamed trickle-down

economics and Reaganomics Real output can be increased in the long run by ensuring that all factors of

production are used effectively and efficiently This goal is best achieved by limiting government intervention in markets and

allowing natural market forces to operate The chief proponent of monetarism is Milton Friedman

Advantages and disadvantages of monetary policy Monetary policy, like fiscal policy, has both advantages and disadvantages Monetary policy has significant advantages in speed, efficacy, and expertise

Unlike fiscal policy, which requires legislation, monetary policy can be enacted swiftly to deal with sudden changes in the economy

Once implemented, however, monetary policy takes longer to impact the economy than fiscal policy

Overall, though, it is still faster If central banks are independent, they are free of political interference or from

public intervention They can pursue unpopular, but necessary, programs such as restricting the

money supply Central banks such as the Federal Reserve are staffed by professionals such as

economists or persons with substantial experience in economics In other words, monetary policy decisions are made by experts

Monetary policy also has its disadvantages Central banks, if independent, may be insulated from the needs of the rest of the

economy while pursuing strict monetary policy goals The lack of accountability for some banks can allow bad bankers to keep their

positions Bad politicians, on the other hand, can be voted out of office

Increasing the money supply may not necessarily boost the economy Consumers and producers must ultimately want the increased money for

inflationary policy to take effect Many economists summarize this difficulty by saying, “You can’t push a

string” Decreasing the money supply, on the other hand, is more effective

Taking money out of people’s hands ensures that they don’t spend it


INTERNATIONAL TRADE AND GLOBAL ECONOMIC DEVELOPMENT

POWER PREVIEW POWER NOTES

This section will focus on trade and development. Trade is principally how economies interact; development (as the term implies) concerns how economies progress from pre-industrial societies to vibrant, more complex, and (usually) wealthier industrial and post-industrial societies.

10% of the exam (5 questions) will focus on trade and development



Economic Growth and Development Trade and interdependence

Global patterns of growth have shown increasing trade among nations and growing interdependence

The term globalization is often used to describe increasing trade and international links

Globalization can be defined in many ways, but it is essentially the spread of economic activity to multiple nations

Increasing foreign trade and investment are the chief indicators of this dispersion Globalization is not a new phenomenon

It has existed in one form or another for centuries Trade networks spanning from the Mediterranean to China existed during the

Roman Empire and brought together vastly different parts of the world Global interdependence also increased dramatically during the 19th century While globalization has certainly been increasing since the end of WWII, levels of

international trade and similar measures of globalization were all actually higher prior to WWI than at present

Globalization can also be expanded to include the free movement of not only goods, services, and investments, but also of people

Past waves of globalization have featured significant migration, mostly from richer areas to poorer or less-developed areas

For example, some Western Europeans migrated to Africa, South America, and South Asia

Current migration patterns indicate movements from poorer areas to richer areas

For example, Mexicans to the US, Turks to Germany, Bangladeshis to the United Kingdom, etc.

Overall, fewer people migrate to other countries now than in the past Globalization is thought to extend economic opportunities to other countries and is

thus considered a boost to development Global patterns of development have shown increasing gaps between Western Europe,

North America, Japan, and Australia and the rest of the world In the early 19th century, “rich” and “poor” nations accounted for roughly equal

shares of world GDP


Since the “poor” areas had more people, however, their per capita GDPs were

significantly lower Currently, wealthier nations account for approximately 80% of world GDP, with

poor nations contributing the remaining 20% At the same time, poorer nations account for about 80% of global population,

meaning that the income of poorer countries is spread among even more people Income inequality between nations is increasing

Income inequality on the national level can be measured in a variety of ways The most common measures of inequality are the Lorenz curve and the Gini

coefficient (discussed in macroeconomics on p. 81) Many measurements of global inequality analyze average income within a country

and compare different countries’ averages A more accurate way of comparing income inequality weighs these averages

by population Patterns of development which have brought about income inequality represent two

trends Western nations and nations heavily influenced by Western ideas (such as Japan

and Australia) have developed much faster than the rest of the world Non-western nations have experienced far larger population growth than

Western nations but less development Global development initially centered on heavy industry and manufacturing but is now

shifting to technology and services Categorizing nations by income

Developed nations are those with a per capita GDP above $10,000 The developed countries include most nations of western Europe and North

America Australia, New Zealand, and some countries in East Asia (Japan, South Korea,

and Singapore) are also considered developed Developed countries also feature a number of other marks of development, such as

long life expectancy, low infant mortality rates, and heavy investment in education Developed countries produce many highly manufactured goods, such as capital

equipment and high technology goods Many, though, are also heavily involved in producing commodities, such as

agriculture in the US and France or minerals in Australia and Canada Most developed countries also feature stabilized populations which are not growing

quickly, if at all Developing countries are those with a per capita GDP between $3000 and $10,000

Developing countries include most of the rest of the world, including India and China

These two countries alone account for roughly a third of the world’s population Some developing countries are comparatively well off, such as Malaysia, Thailand,

most of Latin America, and many of the former communist countries in Europe These countries are sometimes referred to as “middle income” countries

because their per capita GDPs are closer to $10,000 These countries also feature a number of the other signs of development found

in developed countries, such as good healthcare systems, rising life expectancies, falling infant mortality rates, and increasing investments in education

Developing countries typically feature large manufacturing industries but lack the technology or the investment required for more advanced economic activity

Most workers, however, work in agriculture


The developing countries of recent fame are the East Asian Tigers, which include South Korea, Thailand, Malaysia, and Indonesia131

These countries embarked upon a path of state-directed industrial development focused on exports

The Tiger economies grew mostly by producing goods for export to the developed world, often with the help of foreign corporations who brought investment and technology with them

Since the Asian Financial Crisis, the development strategies of the Tiger economies have been heavily criticized

Nevertheless, the Tiger economies were (and in some cases still are) among the fastest-growing in the world

These countries are, in many cases, better off now than they were prior to the period of growth

Less-developed countries (LDCs) are those with a per capita GDP below $3000 LDCs include states that have experienced intense and debilitating conflict (such as

Congo and Somalia), that have suffered from severe disasters (Bangladesh), or which have simply not grown

LDCs are concentrated in sub-Saharan Africa and South Asia but also include countries such as Haiti, Laos, Kosovo,132 and Moldova

They typically feature little, if any, industry Most economic activity is either subsistence agriculture or black market activity

LDCs score very poorly on other indicators of development They suffer from poor public health and little investment in education

Poverty in LDCs There is no single reason why LDCs are extremely poor LDCs often feature quickly growing populations with low life expectancy

The result is a very young population Limited resources are spread over increasing numbers of individuals

LDCs feature few industrial or manufacturing jobs Instead, they rely largely on subsistence agriculture This dependence on agriculture makes LDCs’ economies highly susceptible to

environmental shocks, such as natural disasters and droughts If an LDC’s agriculture is disrupted by a severe disaster, the nation may not be able

to recover, resulting in further economic decline While many might lament that trade exploits workers in LDCs, trade also provides

steady, non-agricultural jobs, which are needed in developing countries LDCs either have populations without the skills to work in export-oriented factories

or have significant internal barriers or disincentives to foreign investment Such barriers include predatory governments, civil wars, ethnic conflict, etc.

LDCs suffer from severe brain-drain Individuals in LDCs that acquire higher levels of education abroad are reluctant to

return to their home country due to low wages and poor quality of life Skilled and educated workers leave their home country in search of opportunities in

more developed economies

131 Vietnam, the Philippines, Hong Kong, Singapore, and even China are also sometimes referred to as Tigers. 132 Provided, of course, that one considers Kosovo to be an independent nation. The Kosovars certainly did when I visited. – Daniel


The emigration of skilled and educated workers leaves LDCs with diminishing

amounts of human capital and deprives them of potential political and economic leaders and innovators

Limitations of per capita GDP Though per capita GDP is a good guide to development, it is limited in truly gauging the

actual quality of life in a country Using per capita GDP as a measure of development results in the same problems

inherent in using GDP as a way of determining the welfare of a given economy GDP does not take into account goods which are not traded on the legal market

In many developing countries and LDCs, many people are involved in subsistence agriculture

The products of subsistence agriculture are consumed directly by the farmer and his or her family rather than sold

The output of subsistence agriculture, since it is not sold, is not factored into GDP

Thus, the true output (and by extension, well-being) of these countries is under-counted and misrepresented

GDP calculations do not factor in unofficial transactions Many LDCs and some developing countries feature extensive black markets

The purpose of these black markets is often to avoid government regulations or price controls

Other times, black markets exist simply because there are no formal markets GDP calculations do not factor these exchanges into account and, thus, leave

some aspects of welfare out of final GDP figures GDP can under-represent other measures of well-being in developing countries

Although other indicators of development such as education and health are often highly correlated with GDP, there are sometimes wide discrepancies between the two

In many former communist countries, for example, extensive social welfare networks and education systems still exist, even as incomes have decreased with the collapse of the state

Per capita GDP does not take these other factors into account Calculating GDP itself can be problematic in many developing countries and LDCs

GDP calculations require accurate, detailed statistics and measurements of the economy, which many poorer nations are simply unable to compile

GDP is difficult to calculate and is subject to revision even in the developed world Japan, for example, generally revises its GDP figures multiple times over many

years Arriving at accurate measurements in poor societies with large informal markets or

in places suffering from conflict, disasters, or other hardships is even harder Poorer countries lack the technical and bureaucratic resources required to

calculate GDP Development and international agencies

To help promote economic development, a number of international organizations lend advice, expertise, or even funds to poorer countries

Two of the most important international organizations that promote economic development are the World Bank and the International Monetary Fund (IMF)

Both the World Bank and the IMF have their origins in the Bretton Woods Conference

Bretton Woods is a town in New Hampshire


In July 1944, the United Nations Monetary and Finance Conference was held to

discuss post-war international payments among both the Allied and (then) enemy countries

44 countries attended the Conference It ultimately dealt with the issue of exchange rates (discussed below) and structuring

international payments to avoid the problems that led to the Great Depression As a result of the Bretton Woods Conference, two organizations emerged

The first was the International Bank for Reconstruction and Development (IBRD), which eventually evolved into the World Bank

The second was the International Monetary Fund (IMF) A third organization, the International Trade Organization, was proposed but

ultimately not created The principles behind the organization were ultimately expressed in the

General Agreement on Tariffs and Trade (GATT) The World Bank is the title assigned to what is officially known as the International Bank

for Reconstruction and Development and several other organizations Following the Bretton Woods Conference, the IBRD was established in 1945 and

became an agency of the United Nations in 1947 The IBRD’s headquarters are located in Washington, DC Its initial purpose was to raise and allocate funds for the reconstruction of Europe

following World War II Eventually, the World Bank’s purpose shifted to providing low-cost loans for

development where private capital is unavailable With time, the IBRD was connected to the International Development Association

(IDA), the International Finance Corporation, and the Multilateral Investment Guarantee Agency to form what is officially known as the World Bank Group

The Bank funds its activities through both member contributions and the sale of bonds

Each member state of the World Bank is required to contribute funds to the bank in accordance with that state’s share of world trade

Previously, countries were obliged to make 20% of their contributions in gold Now, that figure stands at 4.4%

The Bank also acts like a private bank to raise funds: it sells bonds covering its debt on world markets

The World Bank makes loans either directly to the governments of countries or to other parties (with the government acting as the guarantor)

World Bank loans are directed by the IBRD In 2004, the Bank loaned $11 billion to higher-income developing countries Loans from the World Bank through the IBRD are at a cheaper rate than loans

from commercial banks They typically feature a 15 to 20 year window (with a three to five year grace

period) before countries are obliged to begin repaying the loan’s principal The World Bank, through the IDA, also makes direct grants to certain countries to

assist development projects Grants are generally reserved for lower-income countries (such as LDCs)

because these countries can generally borrow only at high interest rates due to the high risk involved

In 2004, the Bank, through the IDA, granted $9 billion for 158 projects in 62 low-income countries


IDA funding for grants comes primarily from contributions made by 40 rich

countries every four years The Bank, through its private activities, also helps fund the grants

More recently, the World Bank group has expanded its operations to include technical advice and expertise in managing economies

It handles special development problems (such as AIDS) and promotes good governance

The World Bank currently has 184 members The current head of the World Bank Group is former ambassador to Indonesia and

former US Deputy Secretary of State Robert Zoellick The International Monetary Fund (IMF) was established following the Bretton Woods

Conference and became operational in 1945 The IMF became a specialized agency of the United Nations in 1947 The primary purpose of the IMF is to pursue the following goals

To encourage international monetary cooperation, particularly with respect to exchange rates

To assist member countries in correcting or avoiding balance of payments difficulties

To encourage global development and the expansion of world trade The initial goal of the IMF was to manage the exchange rates of its member

countries The IMF oversaw the Bretton Woods System of managed exchange rates

The currency exchange rates between countries were fixed, with all rates ultimately tied to convertibility to the dollar

The dollar itself was tied to fixed convertibility to gold The IMF also sought to end all restrictions of foreign exchange and currency

convertibility Most significantly, the IMF acted as a lender of last resort for countries

experiencing balance of payment difficulties so they could maintain their fixed exchange rates and prevent foreign exchange instability

In 1971, the US took the dollar off of the gold standard In 1972, it devalued the dollar relative to all other currencies, effectively ending

the Bretton Woods System of managed exchange rates Initially, the IMF focused on correcting balance of payments problems in wealthier

countries, such as the United Kingdom, France, and even the United States In the 1970s, the IMF shifted its focus from these countries to developing ones

In the 1970s, many developing countries borrowed funds from commercial banks to finance development projects or other schemes

Following the oil shocks and other economic setbacks, developing countries found themselves with massive debts to foreign lenders they couldn’t pay

The IMF, working closely with the IBRD, provided loans at a significantly lower cost to developing countries to cover commercial debts

In exchange for such loans, the IMF required countries to adopt a number of macroeconomic policies to stabilize their economies and to ensure repayment of loans

For example, it required countries to run a budget surplus prior to allocating funds for debt servicing

IMF loans are conditional upon countries accepting these policy recommendations and implementing them

Subsequently, many criticize the IMF as too controlling


The IMF is funded and governed by its member countries Control over the IMF is decided by contributions: countries that contribute

more money to the IMF have higher voting weights This system is similar to the division of control in a corporation based on

stockholders’ shares of ownership The US contributes the most money, so it has the greatest say in the IMF’s

activities How much each member nation has to contribute to the IMF is determined by a

number of economic indicators, such as national income, monetary reserves, and the ratio of exports to national income

Like the World Bank, the IMF has expanded its operations to include technical assistance

One reason for this change is to assist in the implementation of conditions imposed upon borrowing countries

The IMF also takes great interest in non-monetary development problems such as corruption and health crises

The IMF currently has 184 member countries, with total funding at $327 billion In addition to the World Bank and IMF, a number of other international institutions

exist to provide developmental assistance The United Nations has multiple agencies with this purpose

Globally oriented agencies include the UN Conference on Trade and Development and the UN Development Program

A variety of regional agencies operated by the UN also exist, such as the Economic Commission for Europe and the Economic Commission for Africa

UN agencies generally do not provide funding on their own Instead, they work to coordinate and manage aid while providing technical

assistance Multiple regional organizations also exist to foster development

The European Bank for Reconstruction and Development, initially designed to distribute Marshall Plan133 aid, now focuses on providing low-interest loans for development projects in Central and Eastern Europe

The Inter-American Development Bank also provides low-cost loans for development projects, but in the Western Hemisphere (primarily Central and South America and the Caribbean)

Individual countries also create bodies to direct aid and provide technical assistance The US provides aid through the United States Agency for International

Development (USAID) In addition, the United States has recently created the Millennium Challenge

Account This organization provides aid to countries which have achieved good

governance and significantly reduced corruption Other states (or quasi-states) also have their own organizations, such as the EU’s

EuropeAid and the United Kingdom’s Department for International Development

133 The Marshall Plan was a US-funded program to help rebuild Europe after WWII. The Plan also aimed to contain the spread of Soviet ideas and communism in Europe.


International Trade Imports and exports

Exports are goods produced within a country and then sent abroad The U.S., for example, exports Ford Mustangs to Germany

Imports are goods produced outside a country and then purchased by agents in that country

The U.S., for example, imports VW Beetles from Germany A trade deficit occurs when the value of imports exceeds that of exports in a given

country A trade surplus occurs when the value of exports exceeds that of imports Canada is the United States’ chief trading partner

Free trade Free trade exists when there are no non-natural barriers to international trade

Pure free trade is historically rare Natural barriers to trade include geography, distance, and language differences Artificial (non-natural) barriers to trade include all regulations, laws, or other

obstructions enacted by states to reduce, manage, or eliminate trade Types of non-natural barriers to trade

Various artificial barriers to trade currently exist Tariffs are taxes placed upon imported goods

Ad valorem tariffs are based upon a certain percentage of value For example, the government could impose a tariff on all imported cars equal to

2.5% of each car’s value Since ad valorem taxes are based on a percentage, they are not made obsolete

by inflation Ad valorem is Latin for “according to value”

Specific tariffs are based upon the number of goods imported For example, the U.S. could levy a tariff of $5 for every stereo imported Specific tariffs, however, do not account for quality differences

Some stereos will inevitably cost more than others An equal tax on all stereos, regardless of their different values, can be unfair Specific tariffs, therefore, are best suited for homogenous items, such as

apples or oranges Another disadvantage of specific tariffs is that they can become obsolete with

inflation Tariffs restrict trade by raising the price of imported goods relative to domestically

produced goods The goal of a tariff is often to stimulate consumption of domestic goods over

foreign goods Such domestic tariffs cause the domestic consumer to suffer losses

Making the foreign good more expensive than the domestic good coaxes consumers into purchasing the domestic good instead

This domestic good, however, is often more expensive than the foreign good would be without the tariff

The result is that the consumer must pay a higher price Quotas restrict the quantity of a good which can be imported

Absolute quotas restrict the number of goods which can be imported into a country or imported from a specific source

For example, the U.S. could impose a quota stipulating that Germany could only import 20,000 VW Beetles each year to America


Tariff-rate quotas allow for a specified number of goods to be imported at a lower tariff rate

All goods thereafter face a higher tariff rate Since quotas generally do not depend upon price, they can be far more effective in

restraining trade The goods impacted are never allowed into the country in the first place

Compared to tariffs, quotas are relatively easy to implement Most quotas are absolute quotas

Embargoes are restrictions on exports to a specific country with the intention of punishing that country

In the 1970s, for example, OPEC put an embargo on oil to the US, which created a shortage

Embargoes are often used to achieve political ends Import licenses allow only certain firms (or countries) to operate or sell in a given

nation In order to sell or produce in such a nation, a firm must acquire an import license To restrict trade, a nation may either make the price of licenses prohibitively high or

reduce the number of licenses available so only a few firms can operate Non-tariff barriers to trade (NTBT) include a number of product standards and

regulations enacted by a nation Health and safety regulations are a non-natural barrier to trade

Strict standards will cause some nations to be unable to meet inspection and health/safety requirements, effectively banning them from competing

Environmental or labor regulations concern the methods used to produce goods Non-tariff barriers can be enacted for a variety of legitimate reasons In some cases, legitimate social goals can be accompanied by protectionist interests

Under these circumstances, harsh standards are imposed as a means of restricting trade

Adam Smith One of the first theories of foreign trade was Adam Smith’s idea of gains from exchange In Smith’s thought, people (and nations) should specialize in producing a certain good

and then exchange with others to meet all of their needs Production in only one good is more efficient

The result is a decrease in the price of goods and an increase in overall welfare as cheaper goods are exchanged

People can get more of them by exchanging than they could by producing the goods by themselves

The good each economic agent should specialize in is the good in which it has an absolute advantage

Whoever can produce the most of a good with the same quantity of resources holds an absolute advantage in the production of that good

In Smith’s conception of trade, however, those who could not produce goods as efficiently as others are excluded from trade

David Ricardo134 David Ricardo’s expansion of trade theory to include comparative advantage showed

that even individuals or states without an absolute advantage should engage in trade In Smith’s system, gains from exchange can only be realized when two agents have

different efficiencies

134 No relation to Ricky Ricardo. – Lawrence


If one country is better at producing everything than the other, there is no need to trade because the more efficient country would not gain from the exchange

Ricardo demonstrated that trade can still be mutually beneficial even if one party is better at producing everything than another by highlighting comparative advantage

Comparative advantage focuses on the relative prices (or costs) of goods within a country

The relative price of a good is the price of that good in terms of other goods forgone

In other words, a good’s relative price is its opportunity cost expressed in terms of another good

For any country (or person, etc.), a variety of goods can be produced at any one time

To produce one particular good, another must be given up (opportunity cost)

For all persons, parties, or nations, there will be at least one good that each can produce at a lower relative price than all others

In other words, each agent produces one good with a lower opportunity cost than all other agents

According to Ricardo, each agent should specialize in the good for which it has a comparative advantage, regardless of absolute advantage

Persons or countries should then exchange goods with others to meet their needs Absolute advantage is substantially different from comparative advantage

An agent has an absolute advantage in something if it can produce the good more efficiently than all other agents

Absolute advantage implies that some countries or persons might be unable to produce anything more efficiently than others

These persons or countries would be unable to participate in trade The genius of comparative advantage is that even someone who is absolutely dreadful in

producing everything must produce one thing less dreadfully than all others An economic agent should specialize in producing that one thing that it does best

(comparatively) and then trade If relative prices among all goods in two potential trading partners are the same, there

are no gains from trade and they shouldn’t trade Shortcomings of comparative advantage

Ricardo’s model of comparative advantage, while explaining why international trade should occur, does not explain how patterns of trade develop

One peculiar feature of international trade is that most trade is intra-industry135 The United States, for example, trades cars to Europe in exchange for other cars The model of comparative advantage explains the benefits of trading different

goods Intra-industry trade seems to fly in the face of the model

Instead of focusing on comparative advantage, economists have explained intra-industry trade in terms of economies of scale

For certain goods, production becomes most efficient when markets are large

International trade allows firms to operate in markets far larger than domestic markets

135 Unlike “inter-,” which means “between,” “intra-” means “within.”


The model of comparative advantage also does little to explain why some countries

might be better at producing some goods than others The Swedish economists Eli Heckscher and Bertil Ohlin focused on the factor

endowments of countries as a way of explaining comparative advantages A nation’s factor endowment is the availability of the various factors of

production to that nation It explains what countries will be most efficient in producing certain goods

Countries which have abundant labor but not a lot of capital should focus on producing labor-intensive goods while importing capital-intensive goods

For example, they should produce corn and import cars Similarly, capital-rich economies with scarce land should produce capital-intensive

goods and trade them for resources or food For example, they should produce computers and trade for wheat

Protectionist critiques of Ricardo’s theory Protectionism advocates prioritizing and protecting the domestic economy at the

expense of foreign trade Protectionists criticize the theory of comparative advantage for several reasons, all

of which are summarized below Protectionist policy entails tariffs and other taxes on imports to encourage

consumption of domestic goods instead Comparative advantage can cause one nation to become dependent on others to fulfill

its needs If trade is disrupted for any reason (such as war), the nation will not be able to

survive on its own Specialization can lead to unemployment

Those who produce goods for which the nation does not have a comparative advantage will be unemployed when the nation stops producing that good altogether

For example, if Italy has a comparative advantage in wine and trades with the US, all American winemakers will be unemployed if the US stops wine production

New domestic businesses and industries can be driven out of business by foreign competition

These new (“infant”) businesses should be protected from foreign firms This argument is called the infant industry argument

National security should also be prioritized over efficiency For example, the US should not rely on another country to produce its missiles,

even if that country has a comparative advantage An example: comparative advantage in action

Let’s assume we’re looking at two goods (erasers and watches) and three nations (France, Sweden, and Italy)

Sweden has its own production possibilities If Sweden devotes all its resources to watches, it can produce 100 watches If it devotes all its resources to erasers instead, it can produce 50 erasers The relative price of one eraser, therefore, is two watches The relative price of one watch is half an eraser

France has different production possibilities If France produces only watches, it can produce 25 watches If it produces only erasers, it can produce 75 erasers The relative price of one watch is three erasers The relative price of one eraser is one third of a watch

Italy has yet another set of production possibilities


If Italy makes only watches, it can produce 15 of them If it makes only erasers, it can produce three The relative price of one eraser is five watches The relative price of one watch if one fifth of an eraser

First, let’s look at the situation through the eyes of Adam Smith and absolute advantage Sweden has an absolute advantage in the production of watches France has an absolute advantage in the production of erasers Sweden should specialize in watches, France should specialize in erasers, and the

two should trade Neither France nor Sweden should trade with Italy because Italy does not have an

absolute advantage in either good Now let’s look at Ricardo’s perspective and comparative advantage

Because France has the lowest relative price for erasers (one third of a watch), France has a comparative advantage in erasers

Similarly, Italy has the lowest relative price for watches (one fifth of an eraser), so it has a comparative advantage in watches

France should specialize in erasers, Italy should specialize in watches, and the two should trade

The price of each watch should be between one fifth of an eraser and three erasers

This price would be between the relative price each nation would pay if it produced the goods on its own

The price of each eraser should be between one third of a watch and five watches

Again, this price is between the relative prices of the two nations With the above prices, each nation benefits from trade

Neither should trade with Sweden because Sweden does not have a comparative advantage in either good

There must be some other good, however, for which Sweden has a comparative advantage

Sweden should specialize in this one good (whatever it is) and trade for others

Dumping Dumping occurs when a foreign firm sells a good or service domestically at a price

that is below average total cost For example, Ford could sell Mustangs to Germany at a price below the average

total cost of producing Mustangs While dumping may not seem serious, it can drive out domestic businesses

Afterward, the dumping company is free to raise prices as high as it likes136 Using our above example, Ford’s intention could be to drive BMW, Volkswagen, and

other German car companies out of business137 After Ford has achieved this goal, it can raise the price of Mustangs in Germany

as high as it likes Ford’s dumping practices would be described as “predatory”

Predatory means that the dumping is intentional and malicious Dumping is illegal under the international trade rules of the World Trade Organization

(discussed below)

136 This practice is analogous to what WalMart does locally. – Dean 137 Quite the Herculean task if I may say so myself. – Lawrence


The solution to dumping is a tariff on the dumped goods This tariff is called an anti-dumping duty

It raises the price of the good above average total cost The result is a transfer of welfare from the foreign company to the domestic

government The good is more expensive domestically, so it will not be as dangerous to

domestic businesses The government also gets to collect extra revenue

The German government, for example, could levy a tariff on imported Mustangs This tariff would make Mustangs more expensive, encouraging consumers to buy

cars from BMW, Mercedes-Benz, and other domestic companies instead138

International Currency Flows and Exchange Rates Exchange rates

The exchange rate is the rate at which one currency is traded for another Exchange rates are determined purely by supply and demand when trade and foreign

exchange are free If more of a currency is demanded, the price of that currency in terms of other

currencies will increase, or appreciate If less of a currency is demanded internationally, its price in terms of other

currencies will decrease, or depreciate Prices of currencies are quoted in terms of other currencies

For example, the price of one dollar is 0.7234 euros139 Exchange rates are necessary because foreign trade would be impossible without them

Foreign buyers and sellers will (generally) only accept payment for their goods and services in domestic currencies

In Japan, for example, Toyota will only sell cars in exchange for yen To purchase foreign goods and services, people in the US must exchange dollars for

the foreign currency The price of the foreign currency is determined by the supply and demand for

dollars and for the other currency In reality, persons in Japan want to purchase US goods (or financial assets) while

persons in the US want to purchase Japanese items The interaction of the two results in a flow of goods, services, and currencies

between the two countries If a given country runs out of foreign currency and cannot exchange its currency for

others, it will be unable to import any goods or services or pay off debts denominated in foreign currencies

This situation is only applicable when exchange rates are managed (discussed below)

Types of exchange rates Exchange rates can be managed or can be governed purely by market forces When governments do not intervene in foreign exchange markets, exchange rates are

said to be floating or free Floating exchange rates are governed only by the supply and demand for

currencies

138 As if they needed the encouragement. – Dean 139 As of July 18, 2007.


When unmanaged, exchange rates can fluctuate wildly Foreign exchange speculators can also undermine a free-floating currency,

potentially leading to economic crises Speculators buy a currency when its value is low and sell when its value increases

Massive speculation in a currency can disrupt market forces Floating exchange rates are also known as flexible exchange rates

When governments intervene in foreign exchange markets, currencies can either be pegged or managed

Pegged currencies are fixed to a certain value For example, one dollar will always exchange for a certain number of euros or a

certain weight of gold Hard pegs are immobile

Prices will remain fixed regardless of changes Soft pegs allow for some fluctuation in exchange rates

A rate is allowed to move within a narrow range in response to market forces

Managed exchange rates do not feature set targets but do involve heavy government interference in foreign exchange markets

A country with a managed exchange rate will not establish a peg but will instead work to keep its currency from fluctuating too wildly

The primary goal of managed currencies is often to avoid appreciations Any government interference in foreign exchange rates requires governments to

interact with foreign buyers and sellers of currency Since these buyers and sellers are foreign, governments cannot normally just

impose exchange rates Governments have to buy or sell assets priced in their own or other currencies

to manage exchange rates This activity requires large reserves of foreign money

If China wants to keep its currency pegged at a certain level, for example, it has to intervene in markets and buy dollar-denominated assets to manipulate the supply and demand for dollars140

If a country runs out of foreign currency to purchase foreign assets, it will be unable to manage its own currency any longer

The result is a sudden move toward a floating exchange rate which can be very disruptive, as it was in Argentina

Impact of exchange rates on trade Since foreign goods and services can only be bought by trading currencies, the prices of

the involved currencies will significantly impact trade As a currency appreciates141 in value, that country’s exports will become more

expensive to foreigners while imports will become cheaper If the value of the dollar goes up, for example, wine from France will be cheaper for

us to buy In France, however, American goods will be more expensive

As a currency depreciates in value, that country’s exports will become cheaper while imports will become more expensive

If the value of the dollar goes down, for example, Chinese televisions will be more expensive for us to buy

140 China actually did this for a long time. Until the summer of 2005, each yuan was worth exactly $8.28. 141 Remember that “to appreciate” means to increase in value; “to depreciate” means to decrease in value.


In China, however, American goods will be cheaper

Most governments would rather have their currency depreciate than appreciate Currency depreciation acts as a boost to exports while slowing imports, thus

increasing GDP and domestic employment Countries which have to borrow in foreign currencies (such as dollars) are hurt by

depreciation Their currencies become less valuable relative to dollars or other currencies, making

it harder for them to pay off their debts The dollar

The United States’ dollar (USD) is currently the world’s most dominant currency Most goods and services (including commodities) are priced in dollars in international

markets given the size and dominance of the American economy Most countries maintain foreign exchange reserves dominated by dollars

East Asian countries in particular have reserves in dollars For East Asian countries to maintain their currency pegs, they have to

manipulate demand for the dollar by buying and selling US assets Aside from the dollar, there are other significant currencies

The second most-important currency in the world is the euro, which is also the most important currency in most of Europe

The Japanese yen is another important currency in world markets, especially in Asia Other currencies of note include the British pound sterling, the Swiss franc, and the

Chinese yuan142 Balance of payments

There are several account balances that are often mentioned when discussing a nation’s international trade

The balance of payments is the net total of all money and assets going in and out of a nation

Assets coming in are counted as positive Assets leaving are counted as negative The accounts below are specific parts of the balance of payments

The current account includes all short-term payments It includes payments for goods and services

The balance of trade includes the exchange of goods (but not services) It includes physical imports and exports

The balance of services includes the exchange of services (but not goods) It accounts for intangibles rather than physical goods

The United States’ current account balance is negative: more goes out than comes in The capital account encompasses all long-term payments

It includes capital inflow, capital outflow, and financial assets (such as stocks and bonds)

The United States’ capital account balance is positive: more comes in than goes out Terms of trade index

The terms of trade index can also describe the state of a nation’s international trade Average Export Price Index

Terms of trade indexAverage Import Price Index

100= ×

If the index is greater than 100, exports are expensive and imports are cheap

142 Five yuan (about 60 cents) buys you a delicious beef noodle soup. Two Yuan gets you Nance and Joyce Yuan, authors of the Music Fundamentals Power Guide. – Dan and Dean


This situation will probably result in a trade deficit

Domestic consumers will probably buy more imports and firms will be unable to sell as many exports

If the index is less than 100, imports are expensive and exports are cheap This situation will probably lead to a trade surplus

Domestic consumers will probably buy fewer imports, and firms will be able to sell more exports

Trade in the United States Exports

The United States is the world’s second-largest exporter of goods and services In 2004, the US exported slightly over $800 billion worth of goods and services,

accounting for 9% of world exports, second only to Germany Chief exports of the US include intellectual property (from software to popular music),

agricultural products, industrial supplies, and capital equipment Imports

The US is also the world’s largest importer of goods and services The US imported approximately $1.5 trillion worth of goods and services in 2004 Chief imports include primary commodities (such as oil) as well as consumer goods America’s main sources of imports are Canada, China, Mexico, Japan, and Germany (in

that order, from most to least) Trade deficit

The resulting balance of trade has created a large trade deficit Even though the United States is one of the world’s largest exporters, it still imports

more than it sells abroad The United States’ trade deficit has increased steadily since the 1970s

One reason for this trend is the growth of foreign economies, particularly the emergence of strong export sectors in East Asia and (especially) China

More recently, America’s trade deficit reflects the continuing strength of American demand for goods and services while much of the rest of the world (particularly Japan and the EU) is still sluggish

The United States is simply the biggest and most viable buyer of exported goods Some view the growth in the trade deficit as a sign of a weak United States economy

as we rely more and more upon foreigners to satisfy domestic needs Others think that the trade deficit is a sign of strength

Domestic demand is so strong that domestic companies alone cannot keep up with the immense American appetite for goods

In addition to an increasing trade deficit, the United States’ current account deficit has also increased substantially

The current account is a much broader measure of international activity: it includes the flow of investments

Normally, richer nations run current account surpluses while poorer nations run deficits

In a current account surplus, citizens save more, and savings are exported as investments

In a current account deficit, citizens save less, and richer nations fund capital investment in that country

In the United States, other countries have fueled the current account deficit by purchasing American equities (such as stocks), as well as private and public debt


The purchase of public debt in the form of American Treasury bills is one way that some nations, such as China, have maintained their fixed exchange rates with the US

International Organizations and Trade Disputes International trade before WWI

Prior to World War I, international trade was at the highest levels in world history The flow of trade between the European nations, their colonies, and the United States

created a truly globalized world Following WWI, the war debt problems of the European powers led to increasing

protectionism around the world Countries favored domestic producers to boost employment and economic growth

When the Great Depression hit in 1929, the world reverted to full protectionism, particularly with the passage of the Smoot-Hawley Act143 in the United States

This act attempted to ameliorate the economic downturn by placing tariffs on certain imports, thus boosting the consumption of domestic products

Instead, the act backfired as other nations stopped buying exports from the US The Depression only worsened as a result

Trade flows essentially disappeared with the Depression and World War II International trade after WWII

Following the second World War, the major powers (except the Soviet Union) sought to create a framework for promoting and sustaining international trade

Recognizing that competitive tariffs had essentially derailed the world economy and worsened the Depression, the post-war powers sought to reduce protectionism

The first proposal to do so, an institutional International Trade Organization, failed to materialize

In 1947, an agreement was signed in Geneva, Switzerland, creating the General Agreement on Tariffs and Trade (GATT)

The GATT is not an institutional body like the IMF It instead establishes codes of conduct for trade relations and multilateral

negotiations to resolve trade disputes The chief aim of the GATT was the gradual elimination of all tariffs and barriers to

trade The primary principles of the GATT are reciprocity and non-discrimination

Nations reciprocate in creating trade relations All nations are treated the same

The GATT moved forward through several rounds of negotiations designed to further liberalize trade and reduce tariffs

The final GATT round was started in Uruguay in 1986 This round led to the creation of the World Trade Organization (WTO144)

The WTO institutionalized the GATT and several other trade agreements The chief innovation of the WTO was that it added an independent dispute

resolution body to arbitrate trade disputes instead of leaving all disputes to negotiations

The WTO also incorporated two other agreements which were enacted alongside the GATT

143 Sometimes referred to as the Hawley-Smoot Act. 144 Pro skater Rodney Mullen supports that. Rock on. – Zac


The first was the General Agreement on Trade in Services, which covered trade in services such as law and medicine

The second was the agreement on Trade-Related Aspects of Intellectual Property Rights (TRIPs), which covered issues such as patents and copyrights

The WTO brought all of these agreements under one central body with its dispute resolution body

Prior to the WTO, GATT agreements had to be have a consensus: all members had to agree to any new policies or agreements

By introducing the dispute resolution mechanism, the WTO has eliminated the possibility of a single member holding up trade liberalization

The WTO’s headquarters are in Geneva, Switzerland Other agreements and organizations

In addition to the GATT/WTO, a number of regional trade agreements and international economic organizations were enacted in the post-war period

The most significant regional development in the post-war period was the evolution of the European Union (EU)

The European Union is a fledgling “super-state” which now includes 27 European nations

The original member states include Germany, France, the Netherlands, Italy, Belgium, and Luxembourg

The first expansion of the Union included the United Kingdom, Ireland, and Denmark

Later expansion encompassed Spain, Portugal, Greece, Austria, Finland, and Sweden

The latest round of expansion (2004) brought in ten countries, mostly former communist nations: the Czech Republic, Slovakia, Poland, Hungary, Slovenia, Estonia, Lithuania, Latvia, Malta, and Cyprus

Romania and Bulgaria joined the Union in 2007, bringing total membership to 27 nations

Croatia, Serbia, and Turkey are all either starting or in the midst of negotiations to join the Union at a future date

The European Union has evolved significantly since its initial founding in 1951 The European Union is the de facto successor to the European Coal and

Steel Community which liberalized trade in coal and steel among the founding six members

The Union began to take shape as a “super-state” and free trade area with the signing of the Single European Act in 1986

The final step in creating the current European Union was the signing of the Maastricht Treaty, which laid out the criteria for political union and the European Monetary Union (EMU)

The European Union is a customs union Members are obliged to follow the same policies concerning imports, including

universal tariff rates and trade agreements as negotiated by the Union The EU is dedicated to the free movement of goods, services, capital, and people The EU also features its own currency, the euro

The foundations of the euro are in the Maastricht Treaty, which established the criteria for the EMU

The euro was launched in January 1999145

145 The actual coins and banknotes were not fully introduced until 2002.


Members of the euro area include all members of the Union except the United Kingdom, Sweden, and Denmark

The latest 10 entrants to the EU are not yet in the euro area but have pledged to join as soon as they meet the criteria for doing so

Thus far, the euro has made trade among European nations in the euro area far easier

It eliminates the hassle of switching currency in each country In North America, the North American Free Trade Agreement (NAFTA146) is

the primary regional trade agreement covering the United States, Canada, and Mexico Initially, the US and Canada were pursuing a free trade agreement between

themselves in the late 1980s until Mexico’s president, Carlos Salinas, approached the US about starting a regional free trade agreement

NAFTA came into force in 1994 Under NAFTA, the US, Canada, and Mexico are obliged to reduce all tariffs, quotas,

and other trade barriers among themselves within the next 15 years At the insistence of pressure groups primarily in the United States, social and

environmental clauses were added to NAFTA Unlike the EU, NAFTA is not a super-state, as the three countries involved maintain

significant degrees of sovereignty NAFTA does possess a dispute resolution panel to arbitrate trade disagreements

among its three members NAFTA has long been criticized by American workers, who fear that reduced trade

barriers will threaten American jobs The Association of South East Asian Nations (ASEAN) is an organization

dedicated primarily to economic cooperation It also aspires to create a regional free trade agreement Indonesia, Malaysia, the Philippines, Singapore, and Thailand launched ASEAN in

1967 Since its founding, ASEAN has added Vietnam, Myanmar, Laos, and Cambodia to its

membership pool and has worked on forming a special relationship with China ASEAN’s primary purpose has been coordinating regional industrial developments More recently, ASEAN has dedicated itself to creating a regional free trade area and

even proposes the introduction of a common currency ASEAN has a permanent secretariat but lacks many of the institutional features of

NAFTA and (especially) the EU In West Africa, the Economic Community of West African States (ECOWAS)

has sought to create a customs union and free trade area among its members ECOWAS includes all of the nations of sub-Saharan west Africa

Nigeria is by far the largest economy in the community ECOWAS was created by the Treaty of Lagos in 1975 with the aim of forming a

customs union This goal was later expanded to include the development of a free trade area and

cooperation to improve regional infrastructure More recently, ECOWAS has sought to create a common currency

The West African Monetary Institute was created in 2001 as a precursor to a future West African Central Bank

ECOWAS has not been very successful in fostering cooperation among its members, partially due to the instability of some of them (such as Liberia)

146 An anagram of NAFTA is Fanta. Don’t you want a NAFTA? – Patrick


Mercosur is a customs union of South American countries Brazil, Argentina, Paraguay, and Uruguay are the four members of Mercosur

Bolivia, Chile, Columbia, Ecuador, and Peru are associate members Venezuela will become a full member pending ratification by Brazil and Paraguay

Mercosur was launched in 1991 to create a “Southern Common Market,” or customs union, among its four members

Tariffs on intra-Mercosur trade have been abolished Its members are obliged to obey common external tariffs, but this requirement has

been relaxed due to economic crises in member states (primarily Argentina) The G7147 is not so much an international organization or trade agreement but, rather,

an avenue of communication for the world’s largest and richest economies148 Members of the G7 include the US, Japan, Germany, the United Kingdom, France,

Italy, and Canada In 1998, President Clinton formally invited Russia to G7 meetings

Russia has been attending ever since Consequently, the group is now known as the G8

The primary function of the G8 is to serve as a forum of communication and cooperation among the world’s most powerful economies

The G8 forum allows countries to coordinate economic policy to achieve common goals149

The G8 has no formal structure or institutional mechanism The Organization of Economic Cooperation and Development (OECD150) is

similar to the G8 but is somewhat more formal and has a much larger membership The OECD evolved out of the Organization for European Economic Cooperation At present, the OECD has 30 member states, including non-Western states such as

South Korea and Turkey The OECD has several general goals

To encourage economic growth and high employment in member countries To contribute to the economic growth of less-developed member and non-

member states To push for the expansion of international trade

The OECD has a number of committees and performs a variety of statistical and analytical functions but has no binding institutional structure

Like the G8, the OECD primarily serves as a forum to encourage economic cooperation among its members

147 G7 is actually short for “Group of Seven.” 148 I showed up in Calgary once on the eve of a G7 conference. I was coming in for just a day and carrying nothing but a backpack, which probably made me look like a protester, because I was taken into a special interrogation room by the Canadian immigration service. – Dan 149 It also allows certain leaders to thank other leaders for thoughtful gifts, such as “lovely sweaters.” – Dean 150 I have OCD, but that’s totally different. – Dean


POWER LISTS151

TERMS – FUNDAMENTAL ECONOMIC CONCEPTS: Absolute quota Restricts the number of units of a specific good that can be

imported into a country or from a specific source Accounting cost The monetary cost of an item, production, or any other activity;

also known as out-of-pocket expense and explicit cost Accounting profit Equals total revenue minus accounting cost Ad valorem tariff Levied on the value of a good or service; for example, a 2.5% tariff

on the final value of all imported automobiles Allocative efficiency Goods, services, and resources are allocated to the activities that

society values most Bargaining cost Type of transaction cost; includes the value of the time and effort

spent to come to an acceptable agreement, draw up a contract, etc. Barter The direct trade of goods and services for one another; requires a

double coincidence of wants: I must want what you have and you must want what I have for exchange to take place

Bullion Precious metals, such as gold and silver Capital One of the four factors of production; includes all resources used

to produce other goods or services; can be divided into both physical and human forms; does not include money

Capital stock The total pool of capital goods in a nation Capitalism The economic and political theory in which individual economic

agents own the means of production and economic decisions are made in free markets

Ceteris paribus “All else held constant”; an important assumption made in many economic models since so many variables are often involved

Collective action Agents acting together to either coordinate action or to combine efforts to reach common goals

Command economies Economies in which the government plays a significant role; decision-making is generally autocratic in nature or confined to bureaucratic elements which are not responsible to the public for their decisions; one of the two types of planned economies; for example, North Korea

Comparative advantage An individual economic agent’s comparative advantage is whatever good or service it can produce at the lowest relative price (lowest opportunity cost)

Cost-benefit analysis The simplest decision-making model for economics; one compares the costs and benefits of a given activity

Creative destruction Competition and innovation result in the elimination of old firms, practices, goods, etc. over time as they are replaced with newer, more efficient, firms, practices, or goods

151 My former teammate insists that any term from an economics glossary would make an awesome band name. Go nuts. But he has dibs on “Opportunity Cost.” – Patrick


Economic cost The sum of accounting (explicit) and opportunity (implicit) costs Economics The social science of allocating scarce resources among competing

ends Entrepreneurship One of the four factors of production; is human ingenuity which

seeks out new or more efficient combinations of the other three factors of production

Explicit cost See accounting cost; compare to opportunity cost Externality Cost or benefit to an activity that affects a third party; since it is not

faced by the decision-maker, it is not factored into that agent’s decision-making

Factors of production The factors, or inputs, required to produce any good or service Fallacy of composition What’s true for the parts may not be true for the whole Fallacy of division What’s true for the whole may not be true for the parts Free good A good without an opportunity cost, such as air Free market economies Economies in which the government has only a very basic role in

private economics; decision-making on economic matters is completely left to individual economic agents

Human capital Human capabilities such as training, education, and intelligence; can be improved through education

Implicit cost See opportunity cost; compare to accounting cost Import license Government license which only allows firms with government

approval to import (or otherwise supply) a specific good or service in an economy

Incentives Inducements to perform or refrain from a certain activity; in other words, rewards or punishments for certain actions

Indicative economy A type of planned economy characterized by group decision-making and goal-oriented planning

Interest (capital) Payment for capital Invisible hand Postulated by Smith in The Wealth of Nations; refers to the invisible

market forces that guide the market toward equilibrium Involuntary exchange The forced exchange of goods or services between two agents; can

only take place when one or both agents involved are coerced Kaldor-Hicks efficiency Achieved in an economy if it is getting the maximum possible value

out of its resources; those who benefit from the use of these resources are willing to pay just as much as is demanded by those who are harmed

Labor One of the four factors of production; consists of all human physical and mental efforts

Laissez faire Literally “Leave [businesses] alone” Laissez-faire economics An extreme form of free-market economics; the government has

essentially no economic role other than the provision of the most basic of services and the enforcement of the most limited of laws

Land One of the four factors of production; includes all natural resources Law of diminishing marginal

utility As individuals consume greater amounts of a single good or service, each additional unit consumed will bring the consumer less utility


Law of one price Goods and services of uniform quality in free markets will have a

single price; every unit of that item will have the same price Libertarianism An extreme form of capitalism which envisions an extremely limited

government Long run The period of time over which firms can vary all factors of

production Marginal Concerning one more unit of something Marginal analysis A modification of cost-benefit analysis focusing not on all-or-nothing

decisions but on the impacts of incremental changes in behavior on total costs and benefits

Marginal benefit The benefit gained from the consumption or production of one additional unit of a good or service

Marginal cost The cost of consuming or producing one additional unit of a good or service

Market Exists wherever and whenever two or more parties wish to make an exchange

Market forces The effects of supply and demand on behavior; when a given decision or the allocation of resources is decided by supply and demand, it is decided by these

Market systems Markets can be structured in a number of ways depending on who (or what) answers the three fundamental economic questions

Mercantilism A market system featuring heavy government control and regulation of the economy and government manipulation of trade to ensure the steady inward flow of precious metals

Mixed-market economy Economy in which most economic decisions are made in free markets, but the government plays an active role in such decisions through spending or regulation; the dominant type of economy today

Monetary incentive An incentive that involves money Money An item which is used as a medium of exchange, unit of account,

and store of value that is durable, portable, hard to counterfeit, easily divisible, and accepted by all parties

Negative externality Costs from an activity which affect a third party not involved in the activity

Negative incentive An incentive which increases the costs an agent will incur from acting in a certain way; for example, industrial pollution

Non-monetary incentive An incentive that does not have to do with money Non-tariff barriers to trade

(NTBT) Non-traditional, non-monetary barriers to trade such as health and safety requirements

Normative economics Strays from what is factually testable by introducing opinions and preferences; usually marked by statements of what “should be”

Opportunity cost The cost of the next best alternative to a chosen good, service, or activity; also known as implicit cost

Optimization The process by which we attempt to maximize benefits and minimize costs


Out-of-pocket expense See accounting cost Pareto efficiency Achieved in a society if no one person’s welfare could be improved

without detracting from the welfare of another; usually requires that the economy fully utilize all the resources at its disposal

Physical capital Physical goods or other items which are used for the production of other goods or services, such as factory machines

Planned economy Economy in which the government plays a significant role in answering the fundamental economic questions; includes command and indicative economies

Policing and enforcing cost A type of transaction cost; includes the value of the time, effort, and money spent to ensure that the other party of an exchange sticks to agreed terms

Positive economics Economics as science; statements are limited to objective and observable facts that can be tested and proved to be true or false

Positive externality Benefits from an activity which are received by a third-party Positive incentive An incentive which increases the benefits an agent will receive from

acting in a certain way Positive-sum game A situation in which the improvement of any single individual’s

situation does not mean taking something away from someone else; everyone can benefit without anyone losing out

Primary commodities Another name for raw goods; refers to commodities (or goods) immediately after they are extracted from land

Production possibilities The possible combinations of two goods or services that an individual, firm, or society can produce with given factor endowments and productivity

Production Possibilities Curve (PPC)

See production possibilities frontier

Production Possibilities Frontier (PPF)

The graphical representation of the possible combinations of two goods or services that a given agent can produce; all points on the curve are equally efficient, all points inside are inefficient, and all points beyond the curve are impossible without improved factor endowments or increases in productivity; also known as production possibilities curve

Productivity The output of goods or services which a given unit of a factor of production yields

Profit Payment for entrepreneurship; equals total revenue minus total costs

Public monopolies Monopolies which provide vital services; the monopoly is granted by the government for the good of the public

Quotas Restrict the quantity of a good or service which can be imported Raw goods A type of land resource; examples include raw timber or minerals

extracted but not yet refined Regulation Government intervention in an economy or market


Relative price The price of a good or service in terms of the other goods or

services given up; reflects opportunity costs; critical for determining the comparative advantage of economic agents, or what they are best at producing

Rent (traditional) Payment for land; compare to economic rent Resource endowments Another name for factor endowments, but this term often focuses

purely on land endowments Scarcity A fundamental problem that exists with all resources because

human desires are endless and resources are limited Search and information cost Includes the value of all time and effort spent to determine where a

desired good is available, who has the best price, etc.; a type of transaction cost

Short run The period of time over which firms can only vary a few of the factors of production (usually labor and resources) while others are fixed (capital)

Specialization When an individual economic agent focuses on producing a single good or service to take advantage of increased efficiency; agents will then satisfy other needs by trading with others

Specific tariffs Fixed monetary tariffs on each unit of a good or service; for example, a $1.00 tariff on every pair of imported shoes

Sunk costs Costs which have already been paid and cannot be recovered; rational agents ignore sunk costs in decision-making

Tariff Tax paid on imported goods Tariff-rate quotas Quotas which allow for a certain number of goods or services to be

imported duty-free or at one tariff rate, with a higher tariff applying once more goods or services are imported

Trade barrier Any obstruction to trade, including natural and artificial barriers Trade deficit When a country imports more than it exports Traditional economy Economy in which the fundamental economic questions are

answered according to tradition Transaction costs The costs incurred in making an economic exchange; include search

and information, bargaining, and policing and enforcement costs Utility The satisfaction or pleasure that one receives from consuming a

good or service or performing a certain activity Voluntary exchange The consensual trade of goods or services between two agents; will

only take place if both parties expect to benefit from the exchange Wage Payment for labor; generally presented as a rate per hour Wants Unlimited human desires; they are unlimited because they can never

be completely satisfied Zero-sum game A situation in which the improvement of any individual’s position

means that someone else has to lose something

TERMS – MICROECONOMICS: AFL-CIO American Federation of Labor and Congress of Industrial

Organizations; one of the most important labor unions today


Average cost The average per-unit cost of a unit of output; includes both fixed

and variable costs Barrier to entry A difficulty which makes it harder (or impossible) for a firm to enter

a specific market Bilateral monopoly A market with one buyer and one seller Break-even point Level of production at which a firm earns normal profits Budget line A curve, generally a straight line, representing the combinations of

two goods or services that a consumer can buy with his or her current income

Cartel A group of firms that colludes to control prices Closed shop A workplace which only hires union members; outlawed by Taft-

Hartley Act Common stock Owners of this type of stock are the last in line to receive

dividends, but they have a vote in the company Competition policy A variety of public policy tools designed to regulate monopolies and

competition within a select market or the economy as a whole Complementary goods Goods which are consumed together, such as hamburgers and buns;

as the price of a good increases, demand for its complement will decrease; have a negative cross-price elasticity coefficient

Conglomerate merger When two totally unrelated companies merge Consumer surplus The surplus utility received by consumers who would have bought a

good or service at a higher price but only have to pay the market price instead

Contractual savings institutions

Financial institutions such as insurance companies and pension funds which enter into a contract with savers to provide some benefit (such as insurance coverage or future retirement benefits) and which invest current funds by loaning them out to borrowers

Contrived scarcity Monopolists can voluntarily lower production to create scarcity and thus drive up prices

Copyright Grants the exclusive right to reproduce artistic material; lasts the duration of the creator’s lifetime plus 50 years; can create monopolies

Corporate profit tax Special tax on the excess profit of a corporation Corporation Business owned by stockholders Craft union Union made up of members practicing a single craft or job; also

known as trade union Cross-price elasticity Examines the effects that a change in price of one good or service

has on the quantity demanded of another good or service Demand The willingness and ability of consumers to purchase a specific good

or service at any given price Demand curve The quantity demanded at all prices as presented on a graph;

quantity is on the horizontal axis while price is on the vertical axis; has a negative slope

Demand schedule A table presenting the quantity demanded at various prices


Depository institutions Financial institutions such as banks which accept deposits from

savers and make loans to borrowers Depreciation The deterioration of fixed capital over time Derived demand The demand for any factor of production; determined by the

demand for all possible uses of that factor of production Direct correlation Describes the relationship between two variables that change in the

same direction: when one goes up, the other goes up, and vice versa; also known as positive correlation

Discrimination margin The difference between different prices for a firm that practices price discrimination

Diseconomies of scale Exist when production becomes less efficient as output increases Dividends Money paid out to stockholders Division of labor The dividing up of production activities such that an individual is

only responsible for a few (or even one) part of the production process; allows for specialization and productivity gains as individuals become better at their specific tasks

Double coincidence of wants A requirement of bartering; two parties must want what the other has

Due process Legal principle stipulating that the government will not deprive a citizen of his or her basic legal rights

Economic profits Profits over and above opportunity costs Economic rent Return to an input over and above its opportunity cost Economies of scale Exist when production becomes more efficient as output increases Elastic demand Describes a good for which a change in price results in a

proportionally greater change in quantity demanded; elasticity coefficient is greater than one; an increase in price leads to a decrease in total revenue

Elasticity The relationship between two variables, usually expressed as the proportion of change in one variable to change in another variable

Elasticity coefficient The numeric representation of a curve’s elasticity Elasticity of demand Measures the responsiveness of quantity demanded to changes in

price; computed by dividing the percentage change in quantity by the percentage change in price

Elasticity of supply The responsiveness of quantity supplied to changes in price; heavily dependent on time: in the short run, supply is very inelastic because firms cannot vary all factors of production in response to price changes, but in the long run, supply is very elastic because firms can vary all factors of production to respond to price changes

Equilibrium price See equilibrium price

Equilibrium quantity See equilibrium quantity

Exchange price The price at which goods or services are currently bought and sold; also known as equilibrium price and market-clearing price

Exchange quantity The quantity exchanged at the market price; also known as equilibrium quantity


Factor market Market in which factors of production are bought and sold; usually, households sell factors of production while firms consume them

Federal Deposit Insurance Corporation

Insures each deposit up to $100,000 at member financial institutions

Fixed cost The costs of fixed inputs such as factories; cannot change over the short run

Horizontal merger When two companies who produce the same product at the same stage of production merge

Income The flow of money, goods, or services to any economic agent Income effect One of the two reasons for the downward slope of the demand

curve; occurs because as prices for one good increase, consumers can buy fewer units of that good with the same amount of money

Income elasticity Measures the change in quantity demanded as a result of a change in consumer income; if positive, the good is normal; if negative, the good is inferior

Indifference curve A curve which plots the combinations of two goods or services that bring the consumer the same amount of utility

Inelastic demand Describes a good for which a change in price results in a proportionally smaller change in quantity demanded; elasticity coefficient is less than one; an increase in price leads to an increase in total revenue

Inferior goods Goods which are demanded less and less as consumer income increases; for example, shoe repair

Initial public offering (IPO) The price per share of a stock when it first goes on the market Inverse correlation When two variables are inversely correlated, they vary in opposite

directions: when one goes up, the other goes down; also known as negative correlation

Kinked demand curve The demand curve for an oligopolist firm; while other firms will match price decreases, no firm in the market will match a price increase; thus, demand is elastic above the market price and inelastic below the market price

Knights of Labor One of the most important early labor unions; established in 1869 Law of demand As the price of a good or service increases, the quantity demanded

of that good or service decreases (and vice versa) Law of diminishing returns As more of a given factor is employed in an activity, returns (or the

productivity) of that factor will decrease (after a certain point) as it is combined with fixed amounts of other factors

Law of supply As the price of a good or service increases, the quantity supplied of that good or service increases

Luxury goods Have the same relationship to price as normal goods, except consumers will demand more at higher levels of income and almost none at lower levels of income (the relationship is more extreme)

Marginal product The increase in output gained by adding one more unit of a given factor of production

Marginal productivity theory of wages

Firms will continue hiring more laborers until MRP of labor equals the wage rate (MR = MC)


Marginal revenue The additional revenue a firm gains by selling one more unit of a

good or service Marginal revenue product

(MRP) The revenue gained by a firm by selling the output produced by one additional unit of a factor of production; equal to marginal product times marginal revenue

Market clearing price The price at which the quantity supplied is equal to the quantity demanded; all supplied goods are demanded (and consumed)

Market equilibrium When the quantity supplied is equal to the quantity demanded

Market-clearing price See exchange price Merger The union of two or more companies under the same ownership;

one company can buy another or the two can simply combine Microeconomics The study of individual economic agents and markets Monopolistic competition A market structure characterized by many firms supplying similar,

but differentiated, products and competing over both price and non-price factors; there are some barriers to entry because of product differentiation

Monopoly Firm which does not face competition; a market with only one firm Monopoly power The degree to which a firm can charge a higher price for its good

than would prevail if the market were perfectly competitive Monopsony A market with only one consumer Negative correlation See inverse correlation Non-excludable A feature of public goods: once a public good is made available, the

provider cannot exclude anyone from having access to it Non-price competition When firms compete (mainly through advertising) over factors

other than price, such as perceived quality Non-rival A feature of public goods: one person’s consumption of a public

good does not limit the ability of anyone else to consume it Normal goods Goods which consumers will consume more of as income increases

and less of as income decreases Normal profits Profits which exceed accounting costs but which do not exceed

opportunity costs; equal to zero economic profit Oligopoly A market structure characterized by a few firms supplying

homogenous or differentiated products and engaging mostly in non-price competition; significant barriers to entry exist, mostly because of product differentiation and economies of scale

Open shop A workplace where anyone (union or non-union) can work Organization of Petroleum

Exporting Countries (OPEC) Collusive oligopoly that works to artificially raise the market price of crude oil

P/E ratio Ratio of the price of a share of stock to its earnings; represents the number of years it will take a shareholder to make back his money

Partnership Business owned by two or more individuals Patent A legal monopoly granted to a firm to produce a given good or

service in exchange for revealing the product’s exact manufacturing techniques


Perfect competition A market structure characterized by many small firms supplying

essentially identical products and competing on price alone; no barriers to entry

Permanent income Income which is sustainable over a long period of time Picketing Used by union members to draw attention to demands Planned supply The fact that the supply curve only reflects what firms plan to do,

not what they actually do; due to unforeseen events or other developments, the quantity firms actually supply of a given good or service can be significantly different from what they plan to supply given the current market price

Positive correlation See direct correlation Preferences Consumer opinions about what is “in style” and what isn’t; reflect

the popularity of a given good; also known as tastes Preferred stock Owners of this type of stock are paid dividends before owners of

common stock, but they do not have a vote in the company Price ceiling A maximum price for a good or service imposed by the

government; when set below market equilibrium, a shortage will result as consumers demand more than producers are willing to supply

Price competition Firms compete in a market based solely on price Price discrimination Charging different consumers different prices for the same good;

requires dividing the market up in terms of consumer’s elasticities and preventing resale

Price floor A minimum price imposed by the government; when set above market equilibrium, surpluses result as producers supply more than consumers demand

Price-maker Label for monopolistically competitive firms because product differentiation allows for some control over price, but not to the degree of the true monopolist

Price-setter Another name for monopoly firms; a monopolist’s high market power allows it to manipulate supply to charge the price it wants

Price-taker Label for perfectly competitive firms because they can only take the market price; these firms have no control over the market price

Principal The price of a bond; paid back after a specified period of time Principal-agent problem The motivation of agents (managers) to make decisions that benefit

themselves rather than the company and the shareholders (the principals); a big problem for corporations

Private goods Goods which are privately owned, meaning that owners can exclude others from enjoying the benefits and use of that good; both rival and excludable

Producer surplus The surplus that firms which would have been willing to sell their good at lower prices receive by selling at the market price

Product differentiation When firms make their product appear different from other, similar products that fulfill the same function; for example, we consider Nike and Reebok to be very different even though they both make basketball shoes


Proprietorship Business owned by one individual Public employee unions Unions consisting of workers in public (government) employment Public goods Goods which are held by society at large; non-rival and non-

excludable Quantity demanded The quantity of goods or services that consumers demand at a

specific price; corresponds to a point on the demand curve Quantity supplied The quantity of goods or services supplied at a specific price;

corresponds to a point on the supply curve Real wages Wages in terms of real purchasing power (the quantity of goods and

services that one can purchase with the wages); can be calculated using indexation or a deflator

Retained earnings The amount of money made by a corporation that is not distributed as dividends; also known as undistributed profit

Right-to-work laws Made legal by Taft-Hartley act; outlaw union shops; can be passed by states (not passed by federal government)

Shortage Results when more goods or services are demanded than are supplied; can result from a price ceiling

Shut-down point Equal to the minimum of a firm’s average variable costs; if a firm is selling its product for less than this amount, it should close or shut down

Stock Share of ownership in a corporation; two types: preferred and common

Strike When union members refuse to work; used as a bargaining tool Subsidy Monetary incentive given by the government to a firm; increase

supply (shift the curve to the right) Substitute goods A good which can be consumed instead of another without a loss of

satisfaction (utility); a classic example is Pepsi and Coke; as the price of a good increases, demand for its substitute will increase

Substitution effect One of the two reasons for the downward slope of the demand curve; occurs because as the price of one good increases, consumers start to switch to different (but comparable) goods

Supply The quantity of a good or service that a producer is willing and able to produce at any given price

Supply curve The quantity supplied of a good or service at all prices presented as a graph; price is on the vertical axis; quantity supplied is on the horizontal axis; has a positive slope

Supply schedule A table listing the quantity supplied at various prices Surplus Results when more goods or services are supplied than consumers

demand Tastes See preferences Theory of the consumer Another name for the study of demand Theory of the firm Another name for the study of supply Trade union See craft union


Tragedy of the commons Since public goods are non-excludable and can be attained at no

cost, agents overuse them, eventually to the point of depletion; an example is overfishing

Undistributed profit See retained earnings Union shop A place of employment where the employer can hire union

members or non-members; when hired, however, a non-member must join the union

Unit-elastic demand Describes the demand for a good if a change in price results in a proportionately equal change in quantity demanded; a change in price will not change total revenue

Variable cost The cost of variable inputs in the production process, such as labor; increases as more units are produced

Vertical merger When two companies who produce at different stages of production of the same product merge

Yellow-dog contract Agreement signed by an incoming worker in which he or she pledges not to join a union; outlawed by Norris-La Guardia Act

TERMS – MACROECONOMICS: Accelerating inflation When the rate of inflation is increasing Aggregate demand The total demand in the economy at all price levels, which is

reflective of the total expenditures of the economy; total expenditures can be determined by adding all consumer, government, and investment spending to net exports; is graphed much like the market demand curve, except the price level is on the vertical axis and the total level of output is on the horizontal axis

Aggregate supply (long-run) Perfectly vertical: supply is independent of price level (thus, it is perfectly inelastic); shifts inward and outward with long-term changes in technology and productivity

Aggregate supply (short-run) The potential supply of all goods and services at all price levels; is upward-sloping until capacity constraints, after which the curve is vertical since producers cannot produce more even if they wanted to

Antitrust Division, Department of Justice

The federal body charged with managing competition policy by enforcing the US’s antitrust acts

Automatic stabilizers Government policies which work to counteract cyclical changes in the business cycle; these policies are always in place and perform their economic function automatically

Balanced budget multiplier Equal to one; used when the government changes taxes by the same amount as government spending to finance the latter

Base year The price level of this year is the basis for “real” prices Bond A promissory note or I.O.U.; purchased from a company as an

investment in it Bracket creep A consequence of inflation: taxpayers move into higher income tax

brackets simply because their nominal (but not real) incomes have increased; also known as fiscal drag


Bureau of Labor Statistics Compiles a number of economic statistics, including employment

data and the CPI Business cycle A cycle between periods of growth and periods of decline; includes

expansion, peak, downturn, trough Capital gains tax A tax levied on returns from investments, such as the sale of stocks Central banks “Bankers’ banks”; lenders of last resort for private banks; are often

charged with managing the credit and banking systems of a country Check-off provision Employers automatically deduct union fees from employees’ salaries

and pay the fees directly to the union; outlawed by Taft-Hartley Act Circular flow model Shows the links between households, firms, the government,

financial institutions, and foreign nationals as money and output flow through the economy; shows how the different sectors of the economy are interdependent

Classical region (short-run aggregate supply curve)

Vertical, perfectly inelastic region of the short-run aggregate supply curve; in this region, the economy has reached capacity constraints on output, and firms are unable to respond to increases in price level with higher levels of production

Collective bargaining A union negotiates with employers on behalf of every union member

Collusion When firms work together to set prices abnormally high; illegal in the U.S.; most prominent example is OPEC

Commodity money Money made from a material which is useful or valuable in itself, such as gold or silver

Comparative advantage An individual economic agent’s comparative advantage is whatever good or service it can produce at the lowest relative price (lowest opportunity cost)

Constant inflation When prices are increasing at a constant rate Consumer Price Index (CPI) A measurement of inflation which compares the changing price of a

fixed basket of goods over time Consumer spending Spending of all individuals on final goods and services Contractionary policy Policy designed to shrink the economy by reducing either federal

spending or the money supply Corporate income tax See corporate profit tax Corporate profit tax A tax on the earnings of a corporation; also known as corporate

income tax Cost-push inflation Increased factor prices result in increased costs for producers;

higher production costs decrease supply (shift it to the left), resulting in higher prices and inflation

Crowding out Whenever fiscal or monetary policy results in side-effects that counteract the initial actions; for example, expansionary policy often has a small contractionary side effect

Currency The actual paper and coins which circulate in an economy Current economic indicators These provide a sense of general economic activity and include

factors such as employment, producer output, and net exports; take some time to put together and are not in real time, but are still determined fairly quickly


Cyclical unemployment Unemployment resulting from changes in the business cycle Deadweight loss The loss of welfare resulting from increasing the price of a good or

service above its equilibrium value, either through an exercise of monopoly power or through taxes; eliminates a significant portion of the consumer and producer surpluses

Debasement Lowering the precious metal content of coins in order to make more of them from the same amount of the precious metal

Deficit A shortfall in an on-going budget Deflation A sustained decrease in prices over time Deflationary gap An output gap in which actual output is less than potential output Demand deposits A form of money which is stored at banks that can be withdrawn at

any time; examples include most checking accounts; included in M1 Demand-pull inflation The result of increased demand for goods and services when

suppliers are unable to keep up; consumers “bid up” the prices of goods and services, which creates inflation; also referred to as “too many dollars chasing too few goods”

Depression A phase of the business cycle; a downturn that lasts three quarters (nine months) or more

Direct tax Taxes which are applied directly to individual wealth or income Discount rate The rate of interest the Fed charges private banks for loans;

lowering it usually increases private lending, which increases the money supply; increasing it usually decreases private lending, which restricts the money supply

Discouraged worker A persons who could be in the labor force but is no longer actively seeking employment; also known as marginally attached worker

Discretionary spending Federal spending which can be used for any purpose Disinflation When the rate of inflation is slowing down Disposable income Equal to personal income minus income taxes; determines how

much consumers actually consume Downturn A period of the business cycle when economic activity is decreasing Earmarked Federal spending which is set aside for a specific purpose Economic growth A sustained increase in real GDP over time Economic income Income which includes benefits that are not represented in

monetary terms, such as the benefits of improving one’s own household (an activity which does not have a market value)

Embargo Restrictions on exports to a specific country with the intention of punishing that country

Employment rate The percentage of persons in the labor force which have jobs Equation of exchange See quantity theory of money Estate tax Tax on inheritance Eurodollars All dollar accounts held outside the U.S. Excise tax An indirect sales tax that is levied on specific goods or services,

such as alcohol


Expansion A period of the business cycle when economic activity is increasing;

also known as upturn Expansionary policy Policy designed to expand the economy through either an increase

in government spending (fiscal policy) or an increase in the money supply (monetary policy)

Expenditures approach One method of measuring GDP; is the sum of all expenditures in the economy over a given time period; GDP is calculated by adding consumer spending, government spending, investment spending, and net exports

Extended unemployment insurance

Offered during severe economic downturns to supplement and extend existing unemployment benefits

Factor endowment The factors of production available to a nation; has a significant impact on the production possibilities of that agent

Federal Advisory Council Consists of one commercial banker representing each district in the Federal Reserve system; is a purely advisory body with no policy-making power

Federal funds rate The rate private banks charge each other on overnight loans; the Fed does not have direct control over this rate, but instead aims to influence it through open-market operations

Federal Open Market Committee (FOMC)

Trades government securities, or debt, on the open market as a way of conducting day-to-day monetary policy; consists of the Federal Reserve Board plus the President of the New York District Bank and the presidents of four other district banks

Federal Reserve Established in 1913; is the independent central bank of the US Federal Reserve Board The governing body of the Federal Reserve; consists of seven

governors appointed by Congress to 14-year terms with one term expiring every two years

Federal Trade Commission (FTC)

Important government agency that controls competition policy; oversees mergers and works to ensure fair trade

Fiat money Money which is valuable (legal tender) only because a legal authority says it is valuable; nearly all modern money is fiat money

Final goods/services Goods and services not used to produce other goods and services Financial institution Acts as an intermediary between savers and borrowers; provides

services to both, reducing the costs of lending and increasing the benefits of saving

Fiscal drag See bracket creep Fiscal policy Government actions which are designed to increase or decrease

aggregate demand; is enabled by the government’s ability to directly impact aggregate demand by increasing or decreasing its spending

Fisher’s Equation See Fisher’s Hypothesis Fisher’s Hypothesis Nominal Interest Rate = Real Interest Rate + Current Inflation

Rate; also known as Fisher’s Equation Flat tax A type of tax; all individuals pay the same percent tax; also known

as proportional tax Fractional reserve banking Banks keep only a fraction of their deposits and loan the rest out


Free-rider problem A result of the non-excludable nature of public goods; those who

haven’t paid for a public good can still enjoy it Frictional unemployment Unemployment resulting from the time lag between when workers

leave one job and find a new job; exists even in the healthiest and wealthiest of economies

Full employment All resources in the economy (especially labor) are being fully utilized; does not, however, correspond to 100% employment (closer to 96% due to frictional and structural unemployment)

GDP deflator Used to adjust nominal GDP to yield real GDP; a measure of inflation which takes into account all economic activity

Gini coefficient A number from zero to one that represents a country’s distribution of wealth; one means that one individual has all wealth; zero means wealth is distributed equally

Government spending The money spent by the government on final goods and services Gresham’s Law ”Bad money drives out the good”; relates primarily to commodity

money: as two different kinds of money are introduced into an economy, people will hoard “good” money and spend “bad” money; the result is that only “bad” money is present in the economy

Gross Domestic Product (GDP)

The total of all purchases of final goods and services in an economy in one year; can be calculated in multiple ways; focuses on all activity within a nation, thus including the actions of foreign nationals and companies in a given country, but not including the actions of home-country citizens and companies abroad

Human Development Index (HDI)

An indicator published by the United Nations; measures the well-being of nations based upon health and social factors in addition to economic well-being

Hyperinflation When the rate of inflation is extremely high (generally above 20%); an example is the inflation that occurred in Germany after WWI

Incidence of taxation The party in a transaction (consumer or producer) which ends up bearing the burden of a tax; whichever party has a more inelastic demand will bear most of the burden

Income tax A tax on personal income Index of Consumer

Confidence A survey of 5000 households that tracks confidence in the economy; reflects the future economic decisions of households

Index of Leading Economic Indicators

An index of several leading economic indicators published by the US Department of Commerce to measure real-time growth and development

Indirect tax Tax on transactions, especially expenditures; an example is sales tax Industrial union A union consisting of workers with multiple jobs but in the same

industry Inflation A general rise in prices over time Inflationary gap An output gap in which actual output is greater than potential

output; results in inflation Injection Refers to the introduction of resources into the circular flow

model; examples include investment and exports Interest (money) The price of (borrowing) money


Interest effect One reason why aggregate demand is downward sloping: as the

price level increases, more people borrow money, which drives up interest rates; the higher rates discourage investment and consumption, which leads to a decrease in aggregate demand

Interlocking directorate When someone on the board of directors of one company serves on the board of directors of another company; outlawed by Clayton Act for competing companies

Intermediate goods/services Goods and services which are used to produce other goods and services

Intermediate region (short-run aggregate supply curve)

Middle region of the short-run aggregate supply region; upward sloping; increases in output lead to increases in price level (inflation)

Interstate Commerce Commission (ICC)

Established in 1887 to regulate the railroads and protect farmers; disbanded in 1995

Investment spending Total investment expenditures in the economy, including capital investments and inventories

Keynesian region (short-run aggregate supply curve)

Horizontal, perfectly elastic region of the short-run aggregate supply curve; in this region, the economy is in a recession, so increases in output do not lead to increases in price level

L Equal to M3 plus commercial papers, deeds, etc.; its use was discontinued by the Fed in 1998

Labor force The total number of persons aged 16 and over who are either working or actively seeking employment (excluding those who are incarcerated or in the military)

Labor union Organization of workers which provides benefits to members and acts as a bargaining intermediary for individual workers

Laffer curve Curve that shows the relationship between tax rate and tax revenue; at 0% and 100% tax rates, revenue is zero; ideal tax rate is somewhere in between (assumed to be 15%)

Lagging economic indicators Provide an in-depth analysis of economic development and include measurements such as factor costs and GDP; take a great deal of time to put together and are usually retrospective in nature

Leading economic indicators Provide a real-time glimpse of economic activity and include things such as current housing construction and changes in firm orders for resources; easily tracked and readily available

Leakage When resource escape the circular flow model; include imports and savings

Liquidity A term which refers to how easy it is to convert a form of money into something that can be spent immediately (i.e., currency)

Loanable funds The money that one is willing to lend and another is willing to borrow

Loanable funds theory The supply and demand of loanable funds determines the interest rate

Long-run equilibrium State of the economy when the long-run aggregate supply curve passes through the intersection of the short-run aggregate supply curve and the aggregate demand curve


Lorenz curve The graphical representation of the Gini coefficient; shows the

(in)equality of the income distribution of a nation M1 A definition of the money supply that includes all currency, demand

deposits, traveler’s checks, and other deposits against which checks can be written; the most liquid definition of the money supply

M2 Includes all of M1 plus savings accounts, time deposits under $100,000, and balances in retail money market funds; often considered the “best” definition of the money supply

M3 Includes everything in M2 plus time deposits over $100,000, balances in institutional money funds, repurchase liabilities issued by depository institutions, and Eurodollar accounts; discontinued by the Fed in March 2006

Macroeconomics The study of entire economies or societies, as well as the global economy

Marginal propensity to consume

The percentage of every dollar added to income that an individual will spend

Marginal propensity to save The percentage of every dollar added to income that an individual will not spend (save)

Marginally attached worker See discouraged worker Means-tested program Provides aid to individuals whose income falls below a certain

minimum level Medium of exchange Anything which acts as a means of exchanging goods and services;

eliminates the need for barter by providing an intermediary for exchange that can later be traded for other goods or services; most common example is money

Menu cost A cost inflicted by inflation; increasing prices means that firms must continually change the listed prices of goods and services

Monetarists A school of economic thought opposed to Keynes; Milton Friedman was a primary proponent; focuses on increasing aggregate supply through supply-side economics as a means of stimulating the economy and controlling inflation

Monetary base The most restrictive definition of the money supply, limited only to currency

Monetary policy Management of the economy through the Fed, which changes the money supply; tools include open market operations, changes in reserve requirements, and changes in the discount interest rate

Money An item which is used as a medium of exchange, unit of account, and store of value that is durable, portable, hard to counterfeit, easily divisible, and accepted by all parties

Money market accounts A form of account which requires larger-than-normal initial deposits in exchange for higher returns on that deposit; the number of transactions one can make with this type of account is generally limited

Money multiplier The inverse of the reserve requirement (1/RR); used to calculate the change in the money supply that results from a new deposit in a bank


National debt The total amount of money owed by the government; equal to the

sum of all surpluses and deficits in a nation’s history National income The total income of all agents in the economy in a given period;

measurements effectively mirror aggregate demand; equal to NDP minus indirect business taxes

National income approach One method of measuring GDP; add together all payments for the factors of production (wages, rents, interest, and profits) and subtract indirect taxes and subsidies

Natural rate of unemployment

The long-term sustainable rate of unemployment; unemployment above or below this level results in recession or inflation, respectively; equal to about 4%

Net Domestic Product (NDP)

Equal to GDP minus depreciation

Net exports Another term for balance of trade; is a factor of aggregate demand Nominal GDP GDP in current prices Nominal interest rate The interest rate that one receives for a deposit or must pay for a

loan Nominal wages Wages expressed in terms of current price levels (not adjusted for

inflation) Non-excludable A feature of public goods: once a public good is made available, the

provider cannot exclude anyone from having access to it Non-rival A feature of public goods: one person’s consumption of a public

good does not limit the ability of anyone else to consume it Open economy effect See trade effect Open-market operations The buying and selling of government securities on the open market

by the FOMC to manipulate the money supply; buying securities increases the money supply; selling securities decreases the money supply

Output gap The difference between nation’s potential output and actual output; usually calculated by subtracting actual output from potential output

Participation rate The percentage of the total population that is eligible for the labor force that is currently in the labor force (employed or actively seeking employment)

Payroll tax Small tax on employers which is used to fund government programs such as Social Security and Medicare; paid as a portion of workers’ paychecks

Peak The part of the business cycle at the end of an expansion and just before a downturn

Per capita GDP GDP divided by the population; yields the level of national income per person, which is often used as a measurement of economic development and well-being

Personal income Equal to national income minus Social Security tax, plus transfer payments, minus retained earnings

Pigovian tax A tax which aims to discourage a behavior which creates a negative externality; a sin tax is one type of this tax


Planned investment spending The amount that firms plan to invest in a given year; equal to capital

spending plus planned additions to inventories Price stability A goal often assigned to central banks; refers to maintaining

constant rates of low inflation over time Prime rate The interest rate banks charge their best customers Progressive tax A tax which taxes poor individuals at a smaller percentage of

income than rich individuals Proportional tax See flat tax Public goods Goods which are held by society at large; non-rival and non-

excludable Quantity theory of money MV = QP: the amount of money in circulation multiplied by the

velocity of money (how many times a dollar is spent in a year) is equal to the total output of the economy multiplied by the current price level; V and Q are generally fixed, so any change in M will result in a change in P; also known as the equation of exchange

Reaganomics See trickle-down economics Real GDP GDP expressed in constant prices, which allows for comparisons

over time Real interest rate The rate of interest which factors in inflation; calculated by

subtracting the current rate of inflation from the nominal interest rate; can even be a negative number (due to inflation)

Recession A contraction that lasts two quarters (six months) or more Regressive tax A tax which taxes rich individuals at a smaller percentage of income

than poorer individuals Reserve ratio See reserve requirements Reserve requirements The percentage of deposits which banks must keep on hand at any

given time by law; also known as reserve ratio Sales tax A tax on the purchase of goods and services; can be charged to the

producer or the consumer (or both), but the incidence of taxation determines who really bears the burden of the tax

Say’s Law “Supply creates its own demand”: an increase in supply will result in a matching increase in demand to consume the expanded supply; a pre-Keynes conception of supply-side economics

Seasonal unemployment Unemployment resulting from seasonal changes or from work which is only available at certain times of year; for example, life guards are often unemployed in the winter

Shoe-leather costs A cost of inflation; consumers have to go to the bank more often because their money is worth less; the increased “walking to the bank” metaphorically wears out consumers’ shoes

Sin tax Excise tax on items such as alcohol, cigarettes, etc. Spending multiplier

MPC MPS1 1

-1= ; used to calculate the impact of a change in

government spending on GDP Stagflation Occurs whenever economic stagnation and inflation take place at

the same time, such as throughout much of the 1970s


Sticky wages Introduced by Keynes; also known as “rigid” and “inflexible” wages;

workers are reluctant to accept pay cuts, so wages don’t always fall smoothly in response to changes in the economy

Store of value A function of money: money that is earned today retains its spending power in the future; inflation undermines this ability

Structural unemployment Unemployment resulting from fundamental changes in the economy, such as changes in technology or consumer preferences; results from a mismatch of skills offered and skills desired

Supply shock A sudden, external event that affects all producers; usually results in a decrease in aggregate supply; an example is a sudden, dramatic increase in the price of crude oil

Supply-side economics Economic school focusing on changes in supply as the main determinant of total output; proposes that the best way to promote overall welfare is to increase aggregate supply

Tax A compulsory charge or levy enacted by a government to raise revenue; the primary means through which governments fund their activities

Tax multiplier MPCMPS−

; used to determine impact of a change in taxation on GDP

Time deposit A form of money stored at banks which can only be retrieved after a certain length of time; an example is a CD (certificate of deposit)

Total investment spending The sum of planned and unplanned investment spending Trade effect One reason why aggregate demand is downward sloping: as the

price level of domestic goods and services decreases, domestically-produced goods become cheaper abroad, increasing exports and reducing imports, which will increase GDP (output); also known as open economy effect

Trickle-down economics Nickname for the economic policies of President Ronald Reagan; he hoped that tax cuts for corporations would “trickle down” to the middle classes as a result of increased corporate spending; also known as Reaganomics

Trough The part of the business cycle at the end of a downturn and just before an expansion

Tying contract Agreement between one buyer and one seller to deal exclusively with one another; creates a bilateral monopoly

Unemployment insurance Federal and state programs designed to supplement the income of unemployed workers while they search for new jobs

Unemployment rate The percentage of unemployed persons in the labor force (who, by definition, are actively searching for a job)

Unit of account A function of money which allows us to compare the value of different items by looking at their prices

Unplanned investment spending

The amount of a firm’s unforeseen investment, usually in the form of larger or smaller inventories than planned

Upturn See expansion Usage tax Tax designed to support specific government services


Value-added The price a good sells for (as either a final good or an intermediate

good) minus the costs of the resources used to produce it Value-added approach One way of measuring GDP; total the value-added to every good

and service at each stage of production Value-added tax A type of indirect tax which taxes a percentage of the value-added

at every step of the production of a good or service; most developed countries have a value-added tax

Wealth effect One reason why aggregate demand is downward sloping: as the price level decreases, the real income of consumers increases, thus allowing them to purchase more goods and services

Wealth tax A tax on fixed wealth; the most common example is property tax Welfare Government programs designed to ensure the social well-being of

individual citizens

TERMS – INTERNATIONAL TRADE AND GLOBAL DEVELOPMENT: Absolute advantage An economic agent’s ability to produce a good or service more

efficiently than another agent Anti-dumping duty A tariff levied on an imported good to raise its price above its

average total cost, effectively preventing dumping; transfers welfare from the foreign company to the domestic government

Appreciate To increase in value; often used to describe an increase in value in one currency relative to foreign currencies

Association of South East Asian Nations (ASEAN)

An agreement among Southeast Asian nations to eventually create a free trade area and a common currency; members include Indonesia, Malaysia, Thailand, Vietnam, the Philippines, Laos, Cambodia, Singapore, and Myanmar

Balance of payments Includes the total flow of assets and currency in and out of a nation Balance of services Includes the value of all services flowing in and out of a nation Balance of trade The difference between exports and imports, typically presented as

exports minus imports; only includes physical goods Brain-drain The exit of skilled human capital from less-developed countries in

search of opportunities in more developed economies; deprives LDCs of potential innovators and leaders

Bretton Woods Conference Took place near the end of the WWII; was a gathering of the Allied powers to discuss and manage the post-war economic order; resulted in the International Monetary Fund and the International Bank for Reconstruction and Development (which later evolved into the World Bank)

Capital account Includes all long-term payments made in international trade; includes capital inflow/outflow and long-term investments

Current account Includes all short-term payments made in international trade; includes goods, services, investment income, and transfers of assets

Department for International Development

A body in the United Kingdom that provides aid and technical assistance to developing nations


Depreciate To decrease in value; often used to describe a decrease in value in

one currency relative to foreign currencies Developed country Country with a per capita GDP over $10,000 Developing country Country with a per capita GDP between $3000 and $10,000 Dumping When a foreign firm sells a good domestically for a price that is less

than average total cost; described as “predatory” when the intent of the firm is to drive domestic companies out of business

Economic Community of West African States (ECOWAS)

An agreement among west African nations to work toward creating a customs union, free trade area, and common currency; I most significant and largest member is Nigeria

Euro The common currency of the European Union EuropeAid The primary body for coordinating and providing aid from the

European Union European Bank for

Reconstruction and Development

Initially designed as a way to distribute Marshall Plan Aid; is now a body which provides loans and technical assistance throughout Europe and the former Soviet Union

European Coal and Steel Community

The first stage of what is now the European Union; was a free trade area in coal and steel established among France, Germany, Italy, the Netherlands, Belgium, and Luxemburg

European Monetary Union (EMU)

Created the euro, the common currency for several members of the European Union: Ireland, France, Germany, the Netherlands, Belgium, Spain, Portugal, Italy, Luxemburg, Austria, Finland, and Greece

European Union (EU) Created following the Maastricht Treaty; is a customs union and free trade area which also features supranational government and a common currency (the euro)

Export Good or service produced domestically and sold to foreigners Fixed exchange rate When the government intervenes to establish a specific exchange

rate for domestic currency; also known as pegged exchange rate Flexible exchange rate See floating exchange rate Floating exchange rate When exchange rates are set by market forces; also known as

flexible exchange rate Foreign exchange The trade of currencies on international markets Free trade When there are no non-natural barriers to international trade General Agreement on Tariffs

and Trade (GATT) Consisted of a series of agreements which resulted in the gradual lowering of tariffs and other barriers to trade; replaced by the more institutional World Trade Organization in 1994

Globalization The increase in the flow of goods, services, investment, and people between countries

Import Good or service produced by foreigners and sold domestically Infant industry argument A protectionist critique of comparative advantage; argues that we

must protect new (“infant”) industries from foreign competition while as they develop

Inter-American Development Bank

Provides loans and technical assistance to nations in the Western Hemisphere


International Bank for

Reconstruction and Development (IBRD)

Initially set up as a means for distributing aid after WWII; is the loan-granting arm of the World Bank

International Development Association (IDA)

A World Bank member institution; specializes in providing grants to poor countries

International Monetary Fund (IMF)

A lender of last resort for countries; works to prevent balance of payments difficulties and encourage monetary cooperation between nations; primarily provides loans and technical assistance; is also a Bretton Woods institution

Less-developed countries (LDCs)

Countries with a per capita GDP under $3000

Maastricht Treaty Created the European Union and started the process toward greater European political integration and monetary union

Managed exchange rate The government heavily intervenes to manipulate a currency’s value but does not have a specific set or fixed value for it

Mercosur A customs union and eventual free trade area among Brazil, Argentina, Paraguay, and Uruguay, with Chile, Bolivia, Columbia, Ecuador, and Peru as associate members

Millennium Challenge Account

A new body for aid distribution established by George W. Bush; focuses not only on the need of countries, but also on good governance

North American Free Trade Agreement (NAFTA)

An agreement among the United States, Mexico, and Canada; designed to eventually eliminate all barriers to trade between these three countries; is a free trade area only, and does not include a customs union agreement

Organization for Economic Cooperation and Development (OECD)

An organization of (mostly) developed countries which provides technical assistance and allows for some policy coordination among member states

Organization of Petroleum Exporting Countries (OPEC)

Collusive oligopoly that works to artificially raise the market price of crude oil

Pegged exchange rate See fixed exchange rate Protectionism Advocates prioritizing and protecting the domestic economy at the

expensive of foreign trade Relative price The price of a good or service in terms of the other goods or

services given up; reflects opportunity costs; critical for determining the comparative advantage of economic agents, or what they are best at producing

Single European Act 1986; created the single, or common, market for European goods among the members of what was then known as the European Community

Terms of trade index Average Export Price IndexAverage Import Price Index

100× ; if greater than 100, will probably

lead to a trade deficit; if less than 100, will probably lead to a trade surplus


United States Agency for

International Development (USAID)

The primary source of US aid to foreign countries

World Bank A part of the United Nations that specializes in providing loans and grants to developing countries and LDCs; one of the Bretton Woods institutions; includes the IBRD and IDA

World Trade Organization (WTO)

Created in 1994; incorporated the GATT, the General Agreement on Trade in Services, and Trade-Related Aspects of Intellectual Property Rights agreements; contains a dispute resolution mechanism which allows the body to mediate trade disputes between member states

IMPORTANT PEOPLE – ECONOMISTS: Bernanke, Ben Current chairman of the Federal Reserve Engels, Friedrich Coauthored The Communist Manifesto with Marx Fourier, Robert An early utopian socialist; preceded Marx Friedman, Milton Worked with and significantly modified the Fisher Equation to

defend the argument that expansionary monetary policy will only result in inflation and not an increase in real output; important monetarist; responsible for reviving interest in the quantity theory of money

Greenspan, Alan Chairman of the Federal Reserve before Bernanke Gresham, Thomas Namesake for Gresham’s law; an advisor to Queen Elizabeth Heckscher, Eli Studied factor endowment as a way to explain comparative

advantage Keynes, John Maynard 1883-1946; British economist; wrote General Theory of Employment,

Interest, and Money; founder of Keynesian economics: an active government manipulates aggregate demand to close output gaps

Laffer, Arthur Developed Laffer curve; his work was cited as support for Reagan’s tax cuts

Marx, Karl Coauthored The Communist Manifesto with Engels; his work inspired modern communist thought

More, Thomas Early utopian socialist; preceded Marx Nozick, Robert Notable libertarian theorist Ohlin, Bertil Studied factor endowment as a way to explain comparative

advantage Owen, Robert Early utopian socialist; preceded Marx Rand, Ayn Notable libertarian theorist Ricardo, David Authored The Principles of Political Economy and Taxation, which

formed the basis for comparative advantage and modern trade theory

Say, Jean Baptiste Formulated Say’s law, which is the basis for supply-side economics Smith, Adam Wrote The Wealth of Nations (1776); his work founded capitalism

and the formal study of economics


Sweezy, Paul Postulated the existence of the “kinked” demand curve Zoellick, Robert Current head of the World Bank group

IMPORTANT ECONOMIC TEXTS: The Communist Manifesto Book by Karl Marx and Friedrich Engels; published in 1848; laid the

foundation for communist thought General Theory of Employment,

Interest, and Money Written by John Maynard Keynes; discusses the mixed economic system

The Wealth of Nations By Adam Smith; founded capitalism and the formal study of economics; published in 1776; postulates the existence of an “invisible hand”

LAWS – ANTI-TRUST AND FAIR COMPETITION: Celler-Kefauver Act 1950; prohibited any type of merger that gave the merging firms

an unfair advantage in the marketplace Clayton Antitrust Act 1914; prohibited mergers that would result in the creation of

monopolies; also outlaws tying contracts and interlocking directorates

Robinson-Patnam Act 1956; made certain forms of price discrimination illegal; defined “harmful discrimination” as discrimination that leads to unfair competition

Sherman Antitrust Act 1890; designed to outlaw collusion aimed at restricting trade (cartels); made monopolies illegal

Wheeler-Lea Act 1938; gave power to the FTC to investigate unfair, deceptive business practices and prevent false advertising

LAWS – UNIONS: Landrum-Griffith Act 1959; made union leaders more accountable in order to help fight

union corruption National Labor Relations Act 1935; officially legalized unions Norris-La Guardia Act 1932; outlawed yellow-dog contracts Taft-Hartley Act 1947; abolished closed shops; allowed states to pass “right-to-

work” laws; prohibited check-off provisions Wagner Act 1935; guaranteed unions’ right to collective bargaining

LAWS – EMPLOYMENT AND THE GREAT DEPRESSION: Comprehensive Employment

and Training Act 1973; aimed at combating structural unemployment by training structurally unemployed workers with new skills

Employment Act 1946; established maximum (full) employment, production, and purchasing power as official goals of the federal government (but not of the Fed)


Federal Insurance

Contribution Act (FICA) 1939; levied a tax on all citizens’ paychecks to pay for Social Security, welfare, and Medicare

Federal Unemployment Tax Act

1939; levied a small tax on employers to support the general administrative costs of the unemployment compensation system; this tax also covers half of the costs of extended unemployment benefits

Full Employment and Balanced Growth Act

1978; ostensibly made full employment the official goal of the Federal Reserve, but in reality only required the FOMC to testify to Congress twice a year on monetary policy; set 4% as the natural rate of unemployment; nicknamed the Humphrey-Hawkins Act

Hawley-Smoot Act See Smoot-Hawley Act Humphrey-Hawkins Act See Full Employment and Balanced Growth Act Job Training and Partnership

Act 1982; aimed at combating structural unemployment by training structurally unemployed workers with new skills

Manpower Training and Development Act

1962; aimed at combating structural unemployment by training structurally unemployed workers with new skills

Smoot-Hawley Act Passed at the beginning of the Great Depression (1930); sparked a series of tariff hikes throughout the world which essentially ground world trade to a halt, worsening the Depression; sometimes referred to as the Hawley-Smoot Act

Social Security Act 1935; provided workers who lost their jobs with a weekly compensation payment; established the Social Security system

LAWS – OTHER: Commerce Clause A clause in the Constitution (Article I, Section 8) which gives the

US Congress significant jurisdiction over interstate commerce

Federal Reserve Act 1913; created the Federal Reserve System as the central bank of the US

Mack-Saxton Bill Introduced in 1995 and again in 1997; would have made long-term price stability the primary goal of the Federal Reserve

FEDERAL PROGRAMS FOR DOMESTIC AID IN THE US: Aid to Families with

Dependent Children (AFDC) Was part of the 1935 Social Security Act and is administered by the US Department of Health and Human Services; was designed to help families in need with few strings attached until welfare reform during the 1990s

Disaster Unemployment Assistance (DUA)

Unemployment insurance offered in the wake of a severe natural disaster

Earned Income Tax Credit (EITC)

An example of a means-tested program

Food Stamps An example of a means-tested program Medicaid An example of a means-tested program; provides medical assistance

for the needy


Medicare Federal program that provides medical assistance to the elderly Social Security Initially aimed at providing for the elderly and the disabled; started

with the 1935 Social Security Act; is funded on a PAYGO basis: current workers pay for current retirees (“pay as you go”)

Supplemental Security Income An example of a means-tested program Temporary Assistance to

Needy Families (TANF) An example of a means-tested program

Trade Readjustment Allowances (TRAs)

A form of extended unemployment insurance which is offered to workers that have lost their jobs due to foreign trade


POWER EQUATIONS

MICROECONOMICS – ELASTICITY: Arc/midpoint formula for

elasticity of demand 1 0(2

QD QDchange in QD) −

1 0

1 0

1 0

( )(

( ) 2

QD QD(average QD)E

change in P) P P(average P) P P

+ ÷= =

−+ ÷

Cross-price elasticity (%

(%x

y

change in QD )Ec

change in P )=

General equation % Change in Dependent VariableElasticity

% Change in Independent Variable=

Income elasticity

(%(% change in QD)

EI change in income)

=

Point formula for elasticity of demand 1 0

1 0 0

( )%% (

QD QD QD change in QDE

change in P P P P

− ÷= =

− ÷0

)

MICROECONOMICS – OTHER: Average cost (Total Fixed Costs Total Variable Costs)

Average Total CostTotal Number of Units Produced

+=

MACROECONOMICS – PRICE LEVELS AND INFLATION: CPI (to convert currency)

10 1

0

$ x $CPICPI

=

CPI (to find inflation) 1 0

0

100CPI CPI

InflationCPI

−= ×

GDP Deflator (relation to nominal and real GDP) so

Nominal GDP Nominal GDPReal GDP GDP Deflator =

GDP Deflator Real GDP=

GDP Deflator (to convert GDP figures) 1 1

0 0

Deflator GDP

Deflator GDP=

MACROECONOMICS – FISCAL POLICY: Balanced budget multiplier Balanced Budget Multiplier Spending Multiplier Tax Multiplier=

MPC MPC MPSBalanced Budget Multiplier

MPS MPS MPS MPS1 1

( ) 1

+− −

= + = = =


Marginal propensities 1MPC MPS+ = Money multiplier 1

MMRR

=

Spending multiplier 1 11

MultiplierMPC MPS

= =−

Tax multiplier MPCTax multiplier

MPS−

=

INTERNATIONAL TRADE AND GLOBAL DEVELOPMENT: Terms of trade index Average Export Price Index

Terms of trade indexAverage Import Price Index

100= ×


POWER TABLES

FACTORS OF PRODUCTION

Factor What Is It? What Is Its Reward? Examples

Land Natural resources Rent Farmland; oil; water

Labor Human resources Wages Physical or mental activity

Capital Goods used to produced other goods Interest Computers; factory

machinery

Entrepreneurship New or improved ways to produce goods and services Profits

An intelligent businessman invents a new, more

efficient production process for microchips

COMPARING ECONOMIC SYSTEMS

Type of Economy Who Owns the

Means of Production?

Who Makes Economic Decisions?

Who Makes Political Decisions?

Who Receives the Benefits of Production?

Market Economies Individual persons and firms Individuals Individuals Whoever is willing to

pay the most

Indicative Economies

The state The state If democratic, individuals

The state decides how benefits are

distributed

Command Economies

The state The state Dictators, kings, etc. The state decides how benefits are

distributed

Mixed Economies The state and individuals

Primarily individuals with some state

action Individuals

Primarily whoever is willing to pay, but the state will intervene if

necessary

Traditional Economies

Traditional bodies (e.g., the village)

Traditional authorities

Traditional authorities

Traditional allocations


FACTORS WHICH SHIFT SUPPLY

Factor Relationship to Supply

Cost of Inputs Negative/Inverse:

Increase in costs leads to decrease in supply

Technological Progress Positive/Direct:

Increase in technology (technological development) leads to increase in supply

Number of Suppliers Positive/Direct:

Increase in number of suppliers leads to increase in supply

Government Regulations

Taxes—Negative/Inverse: Increase in taxes leads to decrease in supply

Regulations—Negative/Inverse: Increase in regulations leads to decrease in supply

Subsidies—Positive/Direct: Increase in subsidies leads to increase in supply

Expectations of Changes in Price Negative/Inverse: Expectations of lower prices in the future leads to increase in supply now

Prices of Other Goods Produced by the Same Firm

Negative/Inverse: Increase in the price of another good leads to decrease in supply

FACTORS WHICH SHIFT DEMAND

Factor Relationship to Demand Other Notes

Number of Demanders Positive/Direct: Increase in number of demanders leads to increase in demand N/A

Price of Complementary Good

Negative/Inverse: Increase in price of complementary good leads to decrease in demand

Use cross-price elasticity formula to determine if two goods are

complements

Price of Substitute Good

Positive/Direct: Increase in price of substitute goods leads to increase in demand

Use cross-price elasticity formula to determine if two goods are

complements

Consumer Income

Normal goods—Positive/Direct: Increase in consumer income leads to increase in demand

Inferior goods—Negative/Inverse: Increase in consumer income leads to decrease in demand

Use income elasticity formula to determine if a good is normal or

inferior

Tastes or Preferences Positive/Direct: Increase in popularity leads to increase in demand N/A

Expectations

Depends on which factor the expectation is related to

Example: Expectations of higher price in the future lead to increase in demand

N/A


SHIFTS IN SUPPLY AND DEMAND

Demand Shifts… Supply Shifts… Effect on Price Effect on Quantity

To the right No shift Increase Increase

To the left No shift Decrease Decrease

No shift To the right Decrease Increase

No shift To the left Increase Decrease

To the right To the right Unknown Increase

To the right To the left Increase Unknown

To the left To the left Unknown Decrease

To the left To the right Decrease Unknown

? ?

?

?

ELASTICITY

Number Range Name Relation to Total Revenue (TR)

Graphical Representation Other Notes

E = 0 Perfectly inelastic

Increase in price leads to increase in

TR; decrease in price leads to decrease in

TR

Perfectly vertical line Purely theoretical

E < 1 Inelastic

Increase in price leads to increase in

TR; decrease in price leads to decrease in

TR

Steep line

Applies to goods that are necessities and goods that have few available substitutes;

goods are more inelastic in the short

run

E = 1 Unit elastic Change in price has no effect on TR

Line with a slope of 1 or -1

E > 1 Elastic

Increase in price leads to decrease in

TR; decrease in price leads to increase in

TR

Flat line

Applies to goods that are luxuries and

goods that have many available substitutes;

goods are more elastic in the long run

E = ∞ Perfectly elastic Change in price leads to loss of all TR

Perfectly horizontal line Purely theoretical


COMPARING MARKET TYPES

Type of Market

Number of Producers

Kind of Competition

Barriers to Entry

Another Name for Firms

Special Characteristics

Monopoly One None No entry possible Price-setter Only one firm

Perfect Competition

A great many Price competition No barriers (free entry) Price-taker Perfectly elastic

demand

Monopolistic Competition

Many Non-price

competition; price competition

Low barriers (easy entry) Price-maker

Product differentiation and

branding

Oligopoly A few Primarily non-price competition

Medium barriers (difficult entry) N/A Kinked demand

curve

CALCULATING GDP

Method Process

National Income Method Add together all payments for the factors of production and subtract distortions; Wages + Profits + Rents + Interest – Subsidies – Indirect Taxes = GDP

Value-Added Method Sum the value-added for all goods and services at each stage of production; “value-added” is the price a good or service sells for minus the costs of the goods/services or resources used to produce it

Expenditures Approach Add up the value of all finals goods and services in an economy; C + I + G + NX = GDP

TYPES OF UNEMPLOYMENT

Type of Unemployment Definition When It Occurs

Frictional Unemployment resulting from the

time lag between when workers leave jobs and when they find new jobs

Always present in the economy

Structural

Unemployment resulting from structural changes in the economy;

results from a mismatch of skills demanded and skills supplied

Always present in the economy, but can be reduced by retraining

unemployed workers

Cyclical Unemployment resulting from changes in the business cycle

Only occurs with a downturn in the business cycle

Seasonal Unemployment resulting from seasonal changes

Occurs when seasons change, but can be reduced by retraining unemployed

workers


TAXES

Type of Tax Direct or Indirect What Is Taxed Earmarked or Discretionary?

Capital-Gains Tax Direct An additional income tax on investment returns Discretionary

Estate tax Direct Inheritance Discretionary

Income Tax Direct Earned income Discretionary

Payroll Tax Direct Income earned from work Earmarked

Property Tax Direct Property, either at a constant rate or by value

Discretionary (although many states earmark significant portions of

property taxes for education)

Sales Tax Indirect Transactions, either at a constant rate or by value Discretionary

Usage Tax Direct A flat usage fee charged for

using certain facilities or services

Earmarked

MONETARY POLICY

Policy Tool Who Acts? What Happens? How Does It Work?

How Often Is This Tool Utilized?

Open-Market Operations

FOMC The Fed buys and sells US securities

Injects or removes money from the

economy Daily

Discount Rate Board of Governors

The Fed changes the interest rate for loans

from the Fed to member banks

Changes the cost of borrowing from the

Fed, which can encourage or

discourage banks to take out loans

Rarely

Federal Funds Rate Board of Governors The Fed changes

bank-to-bank lending rates

Changes the cost of loans between all

banks

Approximately once per quarter

Reserve Requirements

Board of Governors The Fed changes the reserve requirement

for banks

Changes the amount of reserves banks

must maintain Very rarely


INTERNATIONAL INSTITUTIONS

Institution Purpose Regional or Global? Are Its Actions Binding?

IMF

Provides loans and expertise; serves as an

international lender of last resort

Global Binding

World Bank Provides loans and development assistance Global Binding

WTO

Enforces WTO agreements among member states and moderates disputes among

states

Global Binding

NAFTA Free trade zone in North America Regional Binding

European Union (EU) Political and economic union in Europe Regional Binding

Mercosur Promotes free trade and common tariffs in Latin

America Regional Technically binding

ASEAN Promotes free trade and

common tariffs in Southeast Asia

Regional Technically binding

ECOWAS Promotes free trade and common tariffs in west

Africa Regional Technically binding

OECD A forum for discussion for

the world’s richer economies

Potentially global Non-binding

G7/G8

A smaller discussion forum for the world’s richest economies (G8 also

includes Russia)

Technically global Non-binding


PRACTICE TEST ANALYSIS The Practice Test Analysis can be downloaded by coaches only. All the analyses are available together as the 2007-2008 Practice Test Analysis Power Guide. Ask your coach for a copy.


BIBLIOGRAPHY, ACKNOWLEDGEMENT

REFERENCES:

AmosWeb – GLOSS-arama. AmosWeb*LLC. 11 June 2007 <http://www.amosweb.com/cgi-bin/ awb_nav.pl?s=gls>.

“AS, A2 & IB Economics Revision Notes.” tutor2u. tutor2u. 11 June 2007 <http://www.tutor2u.net/economics/revision-notes/index.html>.

Baumol, William J. and Alan S. Blinder. Economics: Principles and Policy. 9th ed. Texas: South-Western Educational Publishing, 2004.

Dictionary.Com. Lexico Publishing Group, LLC. <http://www.dictionary.com>.

“Economic Theories & Theorists.” Economy Professor. Arts & Sciences Network. 11 June 2007 <www.economyprofessor.com>Error! Hyperlink reference not valid.

Emery, David E. Principles of Economics. Florida: Harcourt, 1985

“Financial Dictionary.” ANZ. Melbourne, Australia. Australia and New Zealand Banking Group, Ltd. 11 June 2007 <http://www.anz.com/edna/dictionary.asp>.

“Notes for Institutions and Markets—Chapter 2.” Finance Professor.com. FinanceProfessor. 6 June 2007 <http://www.financeprofessor.com/fin322/notes/Chapter2-Determinationofinterestrates.htm>.

Samuelson, Paul A. and William D. Nordhaus. Economics. 18th ed. California: McGraw-Hill/Irwin, 2004.

As editor and reviser, I am deeply indebted to Dr. Aksoy, the wonderful economics teacher who taught me almost everything I know about this subject. Many of the preceding pages have benefited from the lecture notes I took during his class. This guide in its present form would not have been possible without him and the inspiration he imparted to my team and to me. Thank you, Dr. Aksoy, for your knowledge, patience, humor, and, above all, your wisdom.

Also, many thanks to Kevin Leung for his research, tips, constructive comments, and “incessant” emails. ☺

http://www.amosweb.com/cgi-bin/


ABOUT THE AUTHOR A grizzled veteran (or an out-of-touch has-been, depending upon your perspective), Joe Slowik competed for two years as an Honors member of Whitney Young’s Academic Decathlon team in 1998-1999 and 1999-2000, serving as team captain his second year.

Following graduation, Joe received a B.A. in philosophy from Michigan State University, and then his M.A. in the Humanities from the University of Chicago.

Presently, when not writing materials for DemiDec in the wee hours of the morning, Joe works as a marketing analyst for McMaster-Carr in Elmhurst, Illinois and is planning on either earning an MBA or a public policy degree in the near future (or both if he feels sufficiently ambitious). Vital Stats:

Competed with Whitney Young High School from Chicago, Illinois, at the national competitions in Anaheim in 1999 and San Antonio in 2000

Though memory now fails him, Joe vividly recalls scoring well above 8000 at most competitions, and narrowly missing (by around 20 points or so) becoming the third-highest scorer in the Honors division in San Antonio

Decathlon philosophy: “Someone, somewhere, is reading through Super Quiz one more time right now… which means you should be doing the same.”


ABOUT THE AUTHOR/EDITOR Dean Schaffer is fond of caves, but only those that have enough light for him to study. He first discovered his affection for secluded spaces in his junior year of high school when he joined Taft High School’s Academic Decathlon team. Two years of grueling hours, tired eyes, and yummy snacks later, he and his team proudly claimed the national title in San Antonio, Texas.

Although he still spends much of his time in non-Decathlon-related caves, Dean makes sure never to neglect his religious principles—he brings a full outfit of pirate regalia and several cases of Ramen noodles everywhere so he may properly and frequently venerate the Flying Spaghetti Monster.152

Although Dean clings to his Monsterism faith pretty strongly, his prayers for better personal foresight have, as of yet, gone unanswered. In high school, he thought he would become a rock star. Last summer, he predicted that his forthcoming career at Stanford University would result in a major in English and a minor in music. One year later, he thinks his plans will more likely involve a major in American studies (with an emphasis on American music) and a minor in classical literature and philosophy. If his track record of accuracy continues, Dean will probably be attending a completely different school with a major in animal husbandry around this time next year.

All personal misconceptions aside, Dean will start his sophomore year at Stanford in the fall, and he couldn’t be happier to be at the school DemiDec Dan once called the “Disneyland of Academia.”

Dean started his DemiDec career by authoring the Renaissance Music Power Guide in the 2005-2006 season. Since the summer of 2006, he has had the privilege of serving as DemiDec’s Power Guide Coordinator, a somewhat ambiguous position which essentially involves Dean slowly evolving into a series of nonsensical bullets. Square, square, circle. BOLD!

If you have any questions, comments, or predictions on Dean’s future, please send him an email at [email protected]. He’ll probably read it, but his response will most likely be in bullet form. Vital Stats:

Competed with Taft High School at the LA regional and California state competitions in 2005; competed at the LA, California, and national competitions in 2006

In 2005, team placed first at regionals and fifth at state with individual scores of 8792 and 8887, respectively

In 2006, team placed first at regionals, state, and nationals with individual scores of 9121, 8903, and 8962, respectively

Decathlon philosophy in a phrase: “Get back to work!” Joined DemiDec in April 2005

152 Visit www.venganza.org if you’re confused.

mailto:[email protected]

ECONOMICS - Carl Schurz High School

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